PROBLEM -

"In my opinion, it will be a mistake if that new plant is built," said Carl Roberts, controller of Tanka Toys. "Why, if that plant was in existence right now, we would be reporting a loss of $100,000 for the fiscal year (1995) rather than a profit, and 1995 sales have been the best in the history of the company."

Mr. Roberts was speaking of a new automated production facility that Tanka Toys is considering building. The company was organized only seven years ago, but it is growing rapidly due to its innovative new toys. Annual sales since inception of the company, along with net income as a percentage of sales, are presented below:

Although the company has always been profitable, in recent years rising costs have cut into its profit margins. The main production plant was constructed in 1989, but growth has been greater than anyone anticipated, making it necessary to rent additional production and storage space in various locations around the country. This "spreading out" of production facilities has caused costs to rise, particularly since the company is somewhat limited in the amount of automated equipment that it can use and therefore must rely on training a large number of new workers each year during peak production seasons.

Tanka Toys produces about 75 percent of its toys between April and September and only about 25% during the remainder of the year. This seasonal production pattern is followed by many toy manufacturers, since it saves on storage costs and reduces the chances of toy obsolescence due to style changes. But more and more toy manufacturers are producing evenly throughout the year, thereby maintaining a stable work force. Alice Clark, manufacturing vice-president of Tanka Toys, is pushing the new plant very hard, since it would permit Tanka Toys to produce on a more even basis, as well as to automate many hand operations and thereby dramatically reduce variable costs.

Tanka's management recognizes that much of the company's success is due to the creative efforts of Golda Frieburg, head of the company's New Products department. Golda has developed new toys that have revolutionized some areas of the toy market. Her talents are now becoming recognized by competitors, and Tanka's management is concerned that one of these competitors may be successful in "buying" her away from the company.

Although total toy sales are quite stable, individual toy manufacturers can experience wide fluctuations from year to year, according to how well their toys are received by the market. For example, Tanka Toys "missed the market" on one of its toy lines in 1993 causing a 20 percent drop in sales and a sharp drop in profits, as shown in the table above. Other manufacturers have experienced even sharper drops in sales, some on a prolonged basis, and Tanka Toys feels fortunate in the sales stability that it has enjoyed.

Mr. Roberts points out that although variable costs will be reduced by the new plant, fixed costs will rise steeply, to $1,700,000 per year. Contrast this with today's fixed costs which are only $450,000 per year. Mr. Roberts is confident (and Ms. Clark agrees) that with stringent cost controls the variable expenses can be held at 82% of sales if the company continues with its present production setup. In contrast, variable expenses will be only 60% of sales if the new plant is built.

Ms. Clark points out that marketing projections predict only a 10 percent annual growth rate in sales if the company continues with its present production setup, whereas sales growth is expected to be as much as 15% annually if the new plant is built. The new plant would provide ample capacity to meet projected sales needs for many years into the future. Economies of expansion dictate, however, that any expansion undertaken be made in one step, since expansion by stages is too costly to be a feasible alternative.

REQUIRED -

1. Assuming that the company continues with its present production setup:

a. Compute the current breakeven point in sales dollars.

b. Prepare a contribution income statement for each of the next three years using project sales as follows, which assumes a 10% growth rate in sales each year (assume that cost behavior patterns remain stable over the three year period):

2. Assuming that the company builds the new plant, redo the computations in (1)(a) and (1)(b) above. Use projected sales as follows, which assumes 15% growth rate each year.

3. Compute the level of sales at which profits would be equal with either the old or new plant.

4. Refer to the original data. Assume that Tanka "misses the market" again and that sales fall by 20% to only $3,200,000 for next year. Compute the net profit or loss for the year with and without the new plant.

5. Refer to the original data. Suppose the company desires to earn a target profit of at least 12% on sales. At what sales level will the 12% target profit on sales be achieved if the new plant is built? According to the company's projected growth in what year will this sales level be reached? At what sales level will the 12% target profit be reached if the company keeps its old plant? How long does it appear that it will take the company to reach this sales level?

6. Using the data you developed in items (1) through (5) above, evaluate the risks and merits of building the new plant and recommend to management the course of action you think should be taken.