Case 2b Mendel Paper Company Produces Foam

Case 2b Mendel Paper Companymendel Paper Company Produces Four Basics

Acquire an understanding of the cost structure and profitability of Mendel Paper Company's four product lines—computer paper, napkins, place mats, and poster board—by analyzing both initial estimates and revised data. Calculate contribution margins per product and per unit, determine break-even points, and assess safety margins with respect to sales volume. Additionally, evaluate the impact of rising variable costs on product profitability and strategic decision-making.

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Mendel Paper Company manufactures four primary paper products: computer paper, napkins, place mats, and poster board. Each product involves distinct materials and operational costs, with market demand reflecting growth in various sectors. The company faces concerns over rising fixed and variable costs, capacity limitations, and profitability, especially in light of increased material costs and potential capacity expansions.

Initially, estimates of sales volumes, prices, and costs provided a foundation for assessing product profitability. For the upcoming fiscal quarter, estimates were as follows:

• Computer Paper: 30,000 units at $14.00; material costs $6.00; variable overhead $9.00 per hour; units per hour: not specified explicitly.
• Napkins: 45,000 units at $7.00; material costs $4.50; variable overhead $6.00 per hour.
• Place mats: 80,000 units at $12.00; material costs $3.60; variable overhead $12.00 per hour.
• Poster board: unspecified units; selling price $8.50; material costs $2.50; variable overhead $8.00 per hour.

Fixed plant overhead is estimated at $420,000 per quarter, with additional fixed selling and administrative expenses of $118,000. The plant's practical capacity is approximately 60,000 machine hours, with current operating levels exceeding this capacity, raising concerns about future costs and capacity constraints.

Cost data includes direct labor which is largely salaried, absorbed into fixed overhead. Variable overheads encompass labor and equipment operational costs, while material costs vary per product. Rising material prices, such as for computer stock and place mats, influence overall costing and profitability.

To analyze product profitability and cost implications, the following objectives are set:

1. Calculate estimated contribution margins per product line and per unit based on original estimates.
2. Compute contribution margins considering revised data, including increased material costs and changed sales volumes.
3. Determine break-even points for both the original and revised sales scenarios, including sales mix considerations.
4. Calculate the margin of safety for both original and revised sales forecasts.
5. Assess the implications of rising variable costs of place mats on overall product profitability and strategic decisions.

This comprehensive analysis facilitates strategic decision-making regarding product continuation, pricing, cost control, and capacity planning, ensuring the company's effective response to market changes and internal cost pressures.

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Introduction

Mendel Paper Company operates within a dynamic market environment characterized by fluctuating demand and cost structures. It manufactures four core products: computer paper, napkins, place mats, and poster board, each with distinct operational and material costs. The company's management efforts focus on evaluating profitability, managing costs, and optimizing capacity amid rising expenses and market opportunities.

Initial Contribution Margin Analysis

Understanding product profitability begins with calculating contribution margins based on initial estimates. Contribution margin per unit is derived as the difference between sales price and variable costs. The contribution margin per unit for each product is as follows:

• Computer Paper: \$14.00 - (\$6.00 + \$9.00 variable overhead) = \$14.00 - \$15.00 = -\$1.00
• Napkins: \$7.00 - (\$4.50 + \$6.00) = \$7.00 - \$10.50 = -\$3.50
• Place mats: \$12.00 - (\$3.60 + \$12.00) = \$12.00 - \$15.60 = -\$3.60
• Poster board: \$8.50 - (\$2.50 + \$8.00) = \$8.50 - \$10.50 = -\$2.00

These calculations suggest that based on initial estimates, all product lines are operating at losses per unit. However, this simplistic calculation ignores the fact that variable overhead per hour relates to machine operation, which affects overall contribution margins. To refine, contribution margins per hour of machine operation must be considered, as detailed below.

Contribution Margin Per Hour of Machine Operation

The contribution margin per hour is computed by dividing the contribution margin per unit by units produced per hour and then subtracting variable costs accordingly, considering the variable overhead per hour. For instance, for computer paper:

• Units per hour: assume the data indicates a productivity of 30,000 units over total machine hours. With total capacity of 60,000 hours, the combined sales should be analyzed to determine hours per product, which isn't specified explicitly. Alternatively, as variable overhead per hour is given, and units per hour are specified for each product, the contribution margin per hour simplifies to:

For computer paper: Contribution margin per hour = Sales price - Material cost - Variable overhead per hour = \$14.00 - \$6.00 - \$9.00 = -\$1.00

Repeating similar calculations for other products yields the same negative contribution margin per hour, indicating unprofitable operation under initial assumptions. These insights necessitate further examination after adjusting for revised estimates, detailed below.

Revised Contribution Margins

Increased material costs for computer stock up to \$7 and for place mats up to \$4 per unit significantly impact profitability. Updated contribution margins per unit are:

• Computer Paper: \$14.00 - \$7.00 - \$9.00 = -\$2.00
• Napkins: remains the same at \$7.00 - \$4.50 - \$6.00 = -\$3.50
• Place mats: \$12.00 - \$4.00 - \$12.00 = -\$4.00
• Poster board: unchanged at \$8.50 - \$2.50 - \$8.00 = -\$2.00

Under revised costs, the contribution margins per unit worsen, underscoring the importance of cost control and strategic review of product lines, especially those with persistent losses.

Break-even Analysis

Break-even volume is found by dividing total fixed costs by contribution margin per unit, or by contribution margin per hour scaled to production capacity and sales mix.

Original Estimates

Assuming a sales mix based on initial volumes, fixed costs of \$538,000 (\$420,000 fixed plant + \$118,000 fixed S&A), and negative contribution margins per unit, the break-even point indicates a need to reevaluate the viability of all product lines. It appears only if costs are significantly reduced or prices increased can profitable operation be achieved.

Revised Estimates

Adjusted for higher material costs and decreased contribution margins, achieving break-even would require substantial cost reductions or price increases. The calculation demonstrates the necessity for strategic adjustments and potentially discontinuing unprofitable lines.

Margin of Safety

Margin of safety is calculated as (Actual or forecasted sales - break-even sales) / actual or forecasted sales.

Under initial estimates, with projected sales exceeding break-even levels, the safety margin might be minimal or negative, implying risk. The revised scenario indicates an increased risk profile due to lower contribution margins and higher costs.

Assessment of Rising Variable Costs for Place Mats

Herbert's concern about the rising variable costs for place mats is valid. The increase from \$3.60 to \$4.00 per unit material cost directly reduces the contribution margin, risking unprofitability. The profit impact is significant, particularly when operating at large volumes, and calls for a reassessment of pricing strategies or cost reductions in material sourcing.

Conclusion

The analysis highlights the delicate balance between sales volume, costs, and profit in manufacturing operations. Rising material costs threaten profitability, especially for lines with narrow or negative margins. Management must consider cost control measures, potential product discontinuation, and capacity adjustments to sustain profitability. Continuous monitoring and strategic planning are crucial in navigating the challenges posed by market and cost fluctuations, ensuring long-term viability.

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