Sub Optima Corporation has been suffering from sales demand at less than full utilization of its capacity.

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Question:

Sub Optima Corporation has been suffering from sales demand at less than full utilization of its capacity. It has two product lines, A and B. Product line A has been weak for several years. Sub Optima has tried to maintain its pricing at $110 a unit, but has steadily lost sales volume until it sells about 100,000 units less than it did five years ago. Last year, the company sold 200,000 more units of product B, but a contract for that many units per year ran out when Sub Optima bid its usual price of $200 a unit. With that contract, product line B had operated at approximately full capacity. However, a competitor, faced with idle capacity, substantially undercut that price. No other Sub Optima customer purchases such a large volume of either product. Below are cost and revenue information and the budget for the current year. Sub Optima is under considerable pressure to turn the projected pre-tax loss into a pre-tax profit.

Budget Information
	Product A	Product B
Sales volume in units	500,000	300,000
Average sales price per unit	$110	$200
Unit cost factors:
Direct material cost	$25	$40
Direct labor	$20	$40
Machine hours per unit	10	15
Overhead:
Variable--per DM$	0.30	0.40
Variable--per DL$	0.50	0.40
Variable--per machine hour	$1.00	$1.50
Fixed--per machine hour	$4.00	$4.00

Budget
	Product A	Product B	Totals
Total revenue	$55,000,000	$60,000,000	$115,000,000

Product costs:
Direct material cost	12,500,000	12,000,000	24,500,000
Direct labor	10,000,000	12,000,000	22,000,000
Overhead:
Variable--based on DM$	3,750,000	4,800,000	8,550,000
Variable--based on DL$	5,000,000	4,800,000	9,800,000
Variable--based on machine hours	5,000,000	6,750,000	11,750,000
Fixed	20,000,000	18,000,000	38,000,000
Total product cost	56,250,000	58,350,000	114,600,000
Gross margin	-1,250,000	1,650,000	400,000
Selling and administrative costs			2,500,000
Income before taxes			-2,100,000
Margin on sales revenue			-1.83%

Management is looking at the possibility of dropping Product A since it is the major cause of the projected loss. However, the VP-Sales has counter proposed dropping the price of A from $110 to $105. She believes that the company can sell an additional 100,000 units with such a drop in price and that competitors will not want to follow the price decrease because they will want to keep up their contribution margins per unit. There are several competitors, so each will lose only a fraction of Sub Optima’s increased sales. However, the CEO is worried that if the competitors do retaliate with similar price cuts, Sub Optima will be stuck with a lower price and the same 500,000 unit volume. If the VP’s scenario proves to be true, is it worth pursuing? Calculate the consequences if the CEO’s worst fear comes true. On what factors should this decision hinge?