Diana has recently followed a course in furniture making and has decided to set up her own

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Question:

Diana has recently followed a course in furniture making and has decided to set up her own workshop from which she will be producing wooden chairs. She starts renting a small workshop at an annual rental cost of $6,000, business rates amount to $1,000 per annum, while workshop heating and lighting will cost $800 annually.

The direct cost information for one wooden chair is given below:

Direct materials: Wood 18

Glue 0.6

Screws 1

Sandpaper 0.4

Direct labour 25

Diana decides that her workshop is capable of producing a normal output of 1000 chairs annually.

(a) Calculate the total product cost of one chair. (2 marks)

Based on calculations of the total product cost per unit, Diana decides to set selling price at $85. She has just heard another entrepreneur talking about break even analysis and she wants to apply this concept in her business.

(b) Calculate the break-even point and Margin of Safety, both in units and value, for the business. (4 marks)

Diana’s friend, who has a degree in marketing, has analysed the wooden furniture market and has suggested that, given the high level of competition, she should reduce her market price to $70, as a result of which sales level will increase by 50%. As the workshop has spare capacity, fixed costs would not change and costs of labour and materials per unit are also expected to remain unchanged at the higher production level.

(c) Find the profit/loss level arising as a result of the lower selling price and advise Diana whether she can go for the price cut. Also, highlight the advantages and limitations of price cuts. (7 marks)

Diana’s business is working well and she is becoming famous in the furniture making market. She has recently received a special order for 50 dining chairs from an NGO. Given that they are a non-profit making organization, they have informed Diana that they can only afford $50 for each chair. Diana knows that her total product cost per unit is higher than the proposed selling price so she is not very keen to accept the special order.

(d) Assuming that the workshop has spare capacity and no other additional costs, other than variable costs of producing the additional chairs would be incurred, advise Diana whether she can accept the special order. Moreover, she wants to know about the possible drawbacks of accepting one off special orders. (6 marks)

(e) How will your advice change if the additional order for 50 chairs implied giving up 50 chairs of current production, assuming there is no spare capacity. (3 marks)

Diana is expanding fast and has more orders than she can currently fulfil with only 2 employees. She now has annual orders for 1500 chairs at a price of $85. She is considering whether to take a third employee. This decision will not increase her fixed costs as she has spare capacity to accommodate another two workers. Best Woods, another furniture-maker, has offered to make the additional 500 chairs for Diana and sell them at a cost of $49 each. Diana is quite happy with this proposal as she knows her total product cost per unit is higher than the proposed price.

(f) Advise Diana whether she should employ the additional worker and do the annual production herself or buy them from Best Woods. Your answer should be supported by both financial and non-financial reasons. (10 marks)

Diana’s business has grown significantly and she is now a successful producer of wooden dining chairs, coffee tables and kitchen cabinets. However, a new government regulation has introduced restrictions on the use of wood with the aim of preserving the natural environment. Diana is therefore facing a shortage of wood, her main raw material.

The expected demand, selling price and variable costs for her three products are as follows:

Dining chair Coffee table Kitchen cabinet

Expected demand (units) 580 500 900

Selling price ($) 85 50 80

Materials (wood) ($) 18 12.60 10.80

Materials (other) ($) 2 5.40 9.20

Direct labour ($) 25 18 30

All three products use the same type of wood at a cost of $1.80 per kg. The government has allocated Diana a maximum of 12,600 kgs of wood. Diana is considering diverting all her production into dining chairs as these provide the highest selling price.

(g) Show that there is a shortfall of materials. Find the optimum production plan for Diana, and calculate the resulting total contribution. (8 marks)

Diana’s friend, using her marketing knowledge has recently undertaken, at the cost of $3,000, a detailed analysis of the emerging trends in the furniture industry. Based on the findings, she suggested that, to remain competitive, the business must add at least one new type of furniture to its existing product mix. Working together with Diana, who has some accounting and finance knowledge, she has come up with two propositions, the Cora and the Dona, which are new design wooden center tables. Due to limited funds, Diana must select only one project.

The Cora is expected to be produced and sold in monthly batches of 5,000 units. Selling price is expected to be $12 in the first 2 years, rising by 5% each year in the following 3 years. Variable production costs would amount to $8 per unit and this is expected to rise by 3% annually over the next 5 years. A special wood cutting machine will have to be bought immediately, costing $900,000 and scrap value is expected to be $50,000 at the end of its lifetime.

The Dona will require investment in a new machine costing $500,000, scrap value being $ 25,000. Monthly production is expected to be 4,000 units. Since it will be using better wood quality, variable costs are expected to be $10 per unit, rising by 5% each year. Selling price would be $13 and this is expected to remain constant.

Both projects would necessitate additional working capital of $50,000 immediately, which will be recovered in full at the end of the project’s life.

Diana is of the view that since Dona requires lower investment and has a higher selling price, it will be more profitable to invest in this project. The cost of capital is 10%

Required: Advice Diana which project is the better investment, supporting your answer with relevant calculations.