Fredonia Inc Had A Bad Year In 2013 For The First Time

Fredonia Inc Had A Bad Year In 2013 For The First Time In Its Histor

Fredonia Inc. experienced a financial downturn in 2013, marking its first loss-making year in history. The company's income statement for that year indicated revenue from selling 76,500 units totaled $1,484,100, but total costs and expenses reached $1,722,200, resulting in a net loss of $238,100. The costs and expenses comprised cost of goods sold (COGS) and other operational expenses, with COGS amounting to $1,198,300—of which $775,600 was variable and $422,700 fixed. Selling expenses were $420,800, with a fixed component of $894,600 and administrative expenses totaled $103,100—both fixed. This financial situation prompted management to evaluate strategic options for 2014 to recover profitability and improve margins.

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Analyzing Fredonia Inc.'s financial scenario from 2013 and projecting alternative strategies for 2014 involves understanding contribution margin concepts, break-even analysis, and cost behavior. The primary goal is to identify the break-even point under current circumstances and assess how each proposed alternative can influence profitability. This comprehensive analysis offers insights into how strategic decisions affect financial outcomes and guides management in selecting the most advantageous course of action.

Financial Overview and Baseline Analysis

The initial step involves calculating the baseline contribution margin ratio and break-even sales, enabling comparison with alternative strategies. The contribution margin (CM) is defined as sales revenue minus variable costs, and the contribution margin ratio (CMR) reflects the proportion of each sales dollar remaining to cover fixed costs and generate profit. It is expressed as:

CMR = (Sales - Variable Costs) / Sales

Given the data from 2013, total sales were $1,484,100, and variable costs amounted to $775,600 (COGS). The variable cost per unit derived from data is approximately $10.14 ($775,600 / 76,500 units), with sales price per unit roughly $19.40 ($1,484,100 / 76,500 units).

Thus, the contribution margin per unit is approximately $9.26 ($19.40 - $10.14), and the contribution margin ratio is approximately 0.4779 (rounded to four decimal places). Using this, the break-even point in dollars can be calculated:

Break-even Sales = Total Fixed Costs / Contribution Margin Ratio

Total fixed costs are fixed components of COGS, selling, and administrative expenses, which sum to $1,244,400 ($422,700 + $894,600 + $103,100). Therefore:

Break-even sales = $1,244,400 / 0.4779 ≈ $2,605,191

This base indicates the sales volume needed to cover all fixed costs under normal pricing and structure.

Impact of Alternative Strategies

1. Increase Unit Selling Price by 24%

Raising the selling price by 24% results in a new unit price of approximately $24.07 ($19.40 × 1.24), with total sales becoming about $1,839,736 (76,500 units × $24.07). Since costs and expenses are assumed unchanged, the contribution margin per unit increases to approximately $13.93 ($24.07 - $10.14). The new contribution margin ratio becomes approximately 0.5784 ($13.93 / $24.07). The revised break-even point:

| Break-even sales = $1,244,400 / 0.5784 ≈ $2,153,825

This strategy significantly lowers the break-even sales threshold, potentially improving profit margins even at modest sales levels.

2. Change Salesperson Compensation to a Hybrid Model

Switching from fixed salaries of $195,100 to a model of $38,800 plus 5% commissions alters fixed and variable expense components. The new fixed costs:

- Fixed compensation: $38,800

- Variable component: 5% of sales ($1,484,100 × 0.05 ≈ $74,205)

- Total sales compensation: $113,005 (fixed + variable)

Previously, fixed sales salary costs were $195,100. Now, the fixed costs are reduced to $38,800, and variable costs increase by $74,205, maintaining the overall expenses similar to before; however, the structure shifts to a variable-based compensation. For break-even analysis, fixed costs are now:

| Fixed costs = $422,700 (original fixed COGS) + $894,600 (fixed admin) + other fixed expenses, assuming no change, total $1,317,300.

But with the compensation change, fixed costs decrease to approximately $1,124,095 ($422,700 + administrative expenses + other fixed costs, minus the reduction). The new contribution margin ratio remains similar, but the variable component of sales expense increases, potentially reducing net profit at higher sales but improving flexibility. The break-even point becomes:

| Break-even sales = Fixed costs / Contribution margin ratio

Assuming fixed costs now are approximately $1,124,095, and contribution margin ratio remains at 0.4779 (assuming costs and prices unchanged), the break-even sales:

| ≈ $1,124,095 / 0.4779 ≈ $2,352,930

This approach reduces fixed costs, lowering the sales threshold to break even and increasing sales responsiveness.

3. Purchase New High-Tech Machinery with a 50:50 Variable:Fixed Cost Ratio

The investment in advanced machinery alters the cost structure, particularly the proportion between variable and fixed costs of COGS. Currently, COGS comprises $775,600 variable and $422,700 fixed costs. The new machinery shifts this to a 50:50 ratio, meaning total COGS will be split evenly between variable and fixed costs, and total COGS may change depending on the cost of the machinery and operational efficiencies.

Assuming the total COGS remains similar, the variable component becomes approximately $599,650 ($1,199,300 × 0.5) and fixed component also $599,650. The change reduces the magnitude of fixed costs in COGS, lowering total fixed costs and potentially modifying the break-even point. The new fixed costs would be:

- Fixed costs: sum of fixed expenses including administrative and selling costs, plus fixed COGS component: $894,600 + $103,100 + $599,650 = $1,597,350

Next, the contribution margin changes as the variable costs decrease to $599,650, per unit variable cost:

| Per unit variable cost ≈ $599,650 / 76,500 ≈ $7.84

And the contribution margin per unit:

| ≈ $19.40 - $7.84 ≈ $11.56

Contribution margin ratio:

| ≈ $11.56 / $19.40 ≈ 0.596

Finally, the new break-even sales:

| = $1,597,350 / 0.596 ≈ $2,679,330

This scenario improves contribution margin and reduces the sales needed to break even, assuming operational efficiencies are realized with new machinery.

Comparison of Strategies and Final Recommendations

Evaluating the three alternatives reveals that increasing the unit selling price offers the most substantial reduction in the break-even sales point, improving profitability margins significantly without additional investments. The shift to a hybrid sales compensation model also lowers the break-even figure by reducing fixed costs, increasing operational flexibility. Conversely, investing in new machinery alters cost structure favorably but entails capital expenditure and implementation risks.

Given these analyses, the optimal strategy depends on company priorities and risk appetite. If the primary goal is quick recovery and minimal upfront investment, raising prices appears most effective, especially if market conditions permit such adjustments. The hybrid compensation plan offers operational flexibility with manageable cost shifts. Investing in machinery can provide long-term operational benefits but requires capital investment and comprehensive evaluation of cost savings and efficiency gains.

In conclusion, for immediate impact and enhanced financial resilience, increasing the selling price stands out as the most straightforward and beneficial course of action. However, a combined approach—implementing price hikes alongside revised sales compensation—might offer synergistic benefits, balancing short-term gains with operational flexibility. Management should consider market competitiveness, customer perception, and capital availability before finalizing the decision.

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