Joe Greco is thinking about starting a company to produce carved wooden clocks. He loves making the clocks and sees an opportunity to be his own boss, making a living doing what he likes best.
Joe paid $300 for the plans for his fi rst clock, and he has already purchased new equipment costing $2,000 to manufacture the clocks. He estimates that it will cost $30 in materials (wood, clock mechanism, and so on) to make each clock. If he decides to build clocks full time, he will need to rent offi ce and manufacturing space, which he thinks would cost $2,500 per month for rent plus another $300 per month for various utility bills. Joe would perform all the manufacturing and run the offi ce, and he would like to pay himself a salary of $3,000 per month so that he would have enough money to live on. Because he does not want to take time away from manufacturing to sell the clocks, he plans to hire two salespeople at a base salary of $1,000 each per month plus a commission of $7 per clock.
Joe plans to sell each clock for $225. He believes that he can produce and sell 300 clocks in December for Christmas, but he is not sure what the sales will be during the rest of the year. However, he is fairly sure that the clocks will be popular because he has been selling similar items as a sideline for several years. Overall, he is confi dent that he can pay all his business costs, pay himself the monthly salary of $3,000, and earn at least $4,000 more than that per month. (Ignore income taxes.) The following questions will help you analyze the information for this problem. Do not turn in your answers to these questions unless your instructor asks you to do so.
REQUIRED INFORMATION ANALYSIS
A. Perform analyses to estimate the number of clocks Joe would need to manufacture and sell each year for his business to be fi nancially successful:
1. List all the costs described and indicate whether each cost is (a) a relevant fi xed cost, (b) a relevant variable cost, or (c) not relevant to Joe's decision.
2. Calculate the contribution margin per unit and the contribution margin ratio.
3. Write down the total cost function for the clocks and calculate the annual breakeven point, in units and in revenues.
4. How many clocks would Joe need to sell annually to earn $4,000 per month more than his salary?
B. Identify business risks concerning the CVP calculations:
1. Explain why Joe cannot know for sure whether his actual costs will be the same dollar amounts that he estimated. In your explanation, identify as many business risks as you can.
2. Identify possible costs for Joe's business that he has not identifi ed. List as many additional types of costs as you can.
3. Explain why Joe cannot know for sure how many clocks he will sell each year. In your explanation, identify as many business risks as you can.
C. Discuss whether Joe is likely to be biased in his revenue and cost estimates.
D. Explain how business risk and Joe's potential biases might affect interpretation of the breakeven analysis results.