This case is designed to assist the student to better understand how cost-volume

This case is designed to assist the student to better understand how cost-volume-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 an establish company to determine in current year of operations how management may apply cost-volume-profit analysis to determine the minimal level of production to achieve profitability. Also, the student is expected to use incremental analysis to evaluate potential business choices in the next year of business with the objective of developing the firm’s profitability.
Background
At one time during your MBA degree, you had the misfortunate of having the worst, ugliest, and meanest instructor in your entire education experience instruct you in managerial accounting. The instructor told you that he was born and raised on the island of Forgotten Island that was a state of the country of Dingy Hole.
The instructor, from Forgotten Island, told you the history of his place of birth and how all the people from that state were quite strange growing two left arms and three feet. He also told you how they always walked sidewards as they did not have a great sense of direction. He stated that when local inhabitants of the island left to visit other parts of the world the additional arm and foot was removed for storage, placed in cryogenics, and then re-attached when the inhabitant returned.
Whilst the thought of such a horrible place scared you, it still excited your interest. Years later you decided to take a trip to see if the stories told by the ugly, mean, and terrible managerial accounting instructor was true. After arriving in the capital of Forgotten Island you were stunned to realize that the stories were true. The local inhabitants did have two left arms and three feet, were extremely ugly, and generally always walked sidewards.
After watching and mixing with the local inhabitants, you suddenly had an idea. How about developing and selling an arm sling device that would help them high the arm out of the way when walking sideways.
Business Idea and Market Analysis
After returning to the UAE you began sketching out a draft of the arm sling device you had in mind. After several design changes and refinement, you were confident you had developed an effective device that would help to improve the lifestyle of the people on Forgotten Island.
You then conducted some market analysis. From Wikipedia, and other sources, you established the current population of the island was 24,000,000 individuals.
The inhabitants of Forgotten Island are the only known people on Earth found to grow two left arms and walk sidewards. After some deep thought you realize it may be a tough task to convince the inhabitants of Forgotten Island to walk forward having perhaps become comfortable walking sidewards.
Nonetheless, you are confident that in the earlier stages of operations (that is, the first year of operations) you will be able to target 1.5% of the total population daily convincing 2% of the local inhabitants of Forgotten Island targeted daily to change the direction in which they walk.
You are confident that the arm sling device you intend to develop will be sturdy; thus, a person is only likely to purchase the device once. The annual calendar on Forgotten Island is 52 weeks with a standard work week of four days with three days of rest and relaxation. Selling of commercial items is not permitted on the days of rest and relaxation.
Operations and Costs in Year 1
To begin your business career, you establish the company Left Swingers Limited.
Realizing the difficulty of selling the item in the first year of operations you project you will require a team of 30 hard core salespersons capable of pounding the ground and making concrete says. The annual salary of each salesperson will be $115,000. To aid in making sales you decide to enact an advertising campaign supported by marketing activities. After reviewing submitted tenders, you decide to you will pay Bluffy Ears Advertising $650,000 for the entire year to conduct the advertising, and Slab Marketing $420,000 for the full year to undertaking the marketing tasks.
To conduct your general administrative and sales operations, you elect to rent an office building agreeing to pay $20,000 per month. In addition, you agree to rent equipment for sales and administration paying $11,500 per month. Also, you agree to an annual telecommunications package with an international service provider to provide internet and telephone services. The annual cost of the services is $460,000.
To store the finished products, you elect to purchase a building for $8,000,000 that will be depreciated using the straight-line depreciation method over a period of 20 years with the building assumed to have zero salvage value. Total utilities expenses for the year to operate the building is estimated to $120,000. The “friendly” financial account also informed you that in the first year the interest and principal costs will amount to $75,000.
To complete the extensive administrative load, you estimate you will need to employ 45 administrative workers with an annual salary of $55,000. To ensure the administrative staff are continuously up to date, you estimate training expenses will amount to $60,000 and another $35,000 of miscellaneous costs.
Based on your final designs you estimate that the direct material costs to manufacture a single unit is $21.50 with direct labour per unit being $37.87. Indirect manufacturing costs for material is $1.70 per unit and $26.05 for indirect labour. The “friendly” management accountant estimated in the first year the applied manufacturing overhead would be $16.69 per unit.
Sales Price Policy
You are not quite certain the precise price to sell each unit. If you use a margin percentage approach you would apply a margin of 40%. If adopting a mark-up approach, you would apply a mark-up of 75%. In the first year of operation, the proposed target net operating profit is $20,000,000.
Operations and Costs in Year 2
Assume that in Year 2 all fixed costs increase by 5% and all variable costs increase by 7%.
Also, your sales team is confident that they can target 2% of the population daily with 2% of the targeted daily population being convinced to buy the product. The total sales for Year 2, based on projections of the sales team, equate to 75% of the maximum capacity of the equipment used in the production of the arm sling device.
You have received a special request from a prospective client from the township of Martian on the west coast of Muddle Creek (a country to the east of Dingy Hole). The prospective client has stated they (the prospective client) would be willing to buy 20,000 units for a special price of $134. To undertake this special order, you will need to increase capacity.
Required:
1. Evaluate, based on the cost structure for Year 1, the financial performance of Left Swingers Limited if the selling price was based on the margin percentage approach rather than the mark-up percentage approach. Discuss any key assumptions.
2. Appraise, by applying Cost-Volume-Profit analysis, the viability of achieving the target net operating profit in Year 1 and the breakeven point. Discuss any key assumptions.
3. Utilizing incremental analysis, evaluate the viability of the special order in Year 2. Propose any quantitative and/or qualitative characteristics that should be considered in assessing
the viability of the special order.

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