This case is designed to assist the student to better understand how absorption costing, costvolume-profit analysis, and

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Question:

This case is designed to assist the student to better understand how absorption costing, costvolume-profit analysis, and incremental analysis can influence business decisions. The case also aids in developing the student’s understanding of the limitations of each respective technique. For this case, the student is being asked to assess a start-up company to determine in the first year of operations how management may cost the item being produced to determine the selling price, and in presenting a projection of the company’s performance across different key margins. The student is also asked to apply cost-volume-profit analysis to determine the minimal level of production in the first year of operations to achieve profitability. Finally, the student is expected to use cost-volume-profit analysis and incremental analysis to evaluate potential business expansion operations in the second year of business with the objective of enhancing firm profitability.

Background:

Alaric Ang and Ian Choo were experienced professional gamers who had competed at professional events throughout Asia. Despite both being born and raised on the small Australian territory of Flinders Island (with a population of just over 25,000 covering an area of 100 square kilometres), neither met till competing in professional tournaments.

Whilst both still considered they had several more years of professional gaming, they shared a joint passion to start a furniture business to manufacture gaming chairs. Throughout many hours of competition, both Ang and Choo had endured many hours of pain that they both attributed to poorly designed gaming chairs. Both felt the pain resulting from the poorly designed gaming chairs had contributed to their poor performance at multiple events.

Economic reports and business analysis suggested gaming would endure expediential growth in the coming years. Ang and Choo were of the opinion the design and manufacturing of gaming chairs offered a business opportunity as there was a gap in the market for gaming chairs that prevented injury and enhanced a player’s performance. They felt ‘gaming chairs designed by gamers for gamers’ would provide enable them to differentiate themselves from existing products.

After developing a business plan, Ang and Choo were able to acquire sufficient seed capital, long-term financing, and short-term lines of credit to found MysteryLab Inc.

Starting Operations

More comfortable developing the business in their home territory rather than a major state capital, Ang and Choo began sketching out the plan for the company’s first year of operations. Due to its isolation of the southern coast of mainland Australia, Flinders Island offered various economic and financial benefits to major state capitals such as zero indirect and direct taxes, lower cost of living, and a moderate temporal climate. However, its isolation requires development of most details supply and distribution logistics. The population of Flinders Island is highly educated with multiple skills-knowledge; however, the average age is higher than the majority of Australia as many young people have taken to migrating to the larger state capitals. The major industries on Flinders Island are dairy farming and cheese manufacturing. Industrial manufacturing, however, is growing progressively leading to the better provision of supply and distribution services.

Though Ang is the majority shareholder in the company with a 75% ownership stake, both Ang and Choo agree that in the early years of operation they will not receive any remuneration unless the company achieves $100 million in sales revenue and/or sustains net income above $10 million for three consecutive years. Furthermore, both agree that neither will take the role of chief executive offer preferring to engage a professional C-Suite manager to oversee the company’s operations. Rather, Ang would take on the role of Design and Production Director and Choo the Sales and Distribution Director.

First Year of Operations

Based on a comprehensive market analysis, Ang and Choo are confident that in the first year of operation MysteryLab Inc would be able to manufacture and sell 75,000 gaming chairs. However, due to prior negative experiences of relatives and friends the two business partners opt for a more conservative option of manufacturing and selling 50,000 units in the first year.

After a lengthy search in the main city of Atlas on Flinders Island, Ang and Choo identified a suitable factory that provided enough space for the maximum manufacturing of 50,000 gaming chairs, housing of the necessary sales team, and room for the administrative personnel. To acquire the factory, MysteryLab Inc would pay $1,000,000. The factory floor space was divided as follows: (a) 60% to manufacturing; (b) 10% to sales; and (c) 30% to administration.

To achieve the maximum planned production capacity of 50,000 in the first year of operation, MysteryLab Inc would acquire production machinery to the value of $500,000.

Consistent with legal requirements, MysteryLab Inc planned on depreciating all fixed assets acquired using the straight-line depreciation method, assuming a useful life of ten years with zero salvage value.

To produce the planned 50,000 gaming chairs in the first year of operation will require 20 skilled production workers. Each production worker that works directly on producing each chair will receive a total remuneration of $60,000 for the year. To ensure the production machinery works effective, MysteryLab Inc will employ 10 staff member who will be paid $8 for each gaming chair manufactured with another 5 employees – paid $4 per gaming chair produced – to clean the manufacturing area to prevent contamination.

Ang and Choo estimate that in the first year of operation, each gaming chair produced will require material costing a total of $40. They (Ang and Choo) estimate that 80% of this material cost will be directly used in each gaming chair manufactured with the remaining being processed as wastage.

MysteryLab Inc will employ 15 salespeople during the first year of operation. A salesperson will be paid $15 for each gaming chair sold. To achieve the aim of selling 50,000 gaming chairs in the first year of operation, it is estimated that the salespeople will incur $75,000 of travelling costs. To complete the company’s administrative requirements during the first year of operation, MysteryLab Inc will employ 10 staff paying them $35,000 each for the year. A chief executive officer – with a fixed annual salary of $350,000 – will be employed in the first year of operation with 50% of the CEO’s work dedicated to the production and 50% to administration.

It is estimated that in the first year of operation the total cost of utilities will amount to $250,000. Of this balance, 15% will be due to the sales activities and 10% to administration.

To start-up the company’s operations in the first year MysteryLab Inc will incur one-off costs of $155,000 for legal fees, $110,000 for company registrations, and $245,000 for set-up costs.

In the first year of operation, Ang and Choo decide to set the selling price of each gaming chair to be based on a 75% mark-up of the estimated manufacturing cost of each gaming chair assuming production and selling capacity to be equal to 50,000 units. Costing of each gaming chair will be based on traditional absorption costing principles.

Potential Expansion

The long-term objective of Ang and Choo is to grow the company and eventual monetize their investment by going public. Such an event is a long, long off. Their first objective is to get the company up and running, and to successful survive the first year. However, being both optimistic about the future, Ang and Choo asked a friend – a leading business development consultant and finance expert – to suggest (assuming the company survived its first year of operation – options for potentially expanding the company in the second year of operations. The consultant – being a friend agreed not to be remunerated immediately but receive a 5% ownership stake if the expansion option is successful – proposed three options for operations in the second year.

Second Year of Operations

Ang and Choo are contemplating three possible strategic manufacturing options based on the following parameters:

Option 1: Leave the production and sales levels equivalent to the first year of operations. All production, sales, and administration costs will remain equivalent to that in the first year of operation.

Option 2: Increase the production and sales to a maximum capacity of 100,000 units. To achieve this objective, MysteryLab Inc would undertake the following operational changes: a) The original factory (designated Factory 1) will continue to operate within similar parameters as in the first year of operation with the following minor adjustments:(i) maintenance workers will be paid on an hourly rate of $8.00 per hour rather than on the basis of each unit produced by the factory; and (ii) factory cleaning staff will be paid on an hourly rate of $4.00 per hour rather than on the basis of each unit produced by the factory. It is estimated the maintenance workers will be required to complete 35,000 hours of work during the second year of operation whilst the cleaning staff will complete 20,000 hours of work.

b) A second factory (designated as Factory 2) – being of precisely the same dimensions and configuration as Factory 1 – will be rented for a total cost of $150,000. The rental cost will be apportioned to production, sales and administration based on the floor space of each area of operation. For the operating of Factory 2 the following costs will be incurred: i. All machinery will be rented with a total annual cost of $75,000. ii. Production workers will be paid on an hourly basis of $38 per hour. It is estimated in the production workers in Factory 2 will work a total of 25,000 hours in the second year of operation. iii. Maintenance workers will be paid on an hourly rate of $7 per hour completing a total of 35,000 hours during the year. iv. Cleaning staff working in the factory production area paid an hourly rate of $3 per hour for an estimated total of 20,000 hours for the year. v. Direct material cost to produce each gaming chair in Factory 2 is estimated to be $36 with $3 of indirect material costs. vi. Salespeople employed to sell production from Factory 2 will be paid at same rate and terms as salespeople employed to sell Factory 1 production with total sales travel costs being equivalent as for Factory 1. vii. Total utility costs of Factory 2 are equal to Factory 1 and apportioned on same basis as Factory 1.

c) The annual salary of the chief executive officer will be increased to $500,000 with the chief executive officer overseeing operations of both Factory 1 and Factory 2. The chief executive officer will continue to allocate 50% of time to production and 50% to administration.

d) No additional administration staff will be employed. The administration staff employed will cover the administration work in Factory 1 and Factory 2. Administration staff costs will not change from the first year of operations.

e) The selling price of each gaming chair will be reduced to $121.

f) It is assumed total production and sales in the second year of operation will be equal to the maximum production capacity of Factory 1 and Factory 2.

Option 3: Maintain production and sales at the same level as in the first year of operation; however, the quality of each gaming chair will be improved. This will be achieved by following adjustments in the operations:

a) Production workers salary will be increased to $55 per gaming chair manufactured. The total number of chairs produced will be equal to the maximum production capacity of the factory.

b) Cost of direct material used in the production of each gaming chair increased to $46 with indirect material costs remaining the same as in the first year of operation.

c) Selling price for each gaming chair produced in the second year of operation will be set at $199.

d) All other costs production, sales, and administration costs remain the same in the first year of operation.

Assessment Tasks.

1. Appraise the projected costing structure of ‘Mystery Lab Inc’ in the company’s first year of operation in applying absorption costing techniques to determine the estimated cost and selling price per unit in creating a profit and loss budget with discussion of key assumptions and/or limitations.

2. Apply Cost-Volume-Profit analysis to calculate the breakeven point in units for ‘MysteryLab Inc’ in the first year of production and evaluate the project’s viability if required to achieve the targeted net income in the company’s first year. Discuss any key assumptions.

3. Applying incremental analysis and Cost-Volume-Profit analysis, evaluate the proposed option ‘MysteryLab Inc’ may adopt in the second year of production, and propose any quantitative and/or qualitative characteristics that should be considered in selecting the appropriate option to best enhance performance.

Please, the report should include:

1. Executive Summary

2. Introduction

3. Answer requirements 1, 2, & 3

4. Conclusion