Last Year A Toy Manufacturer Introduced A New Toy Truck

Last Year A Toy Manufacturer Introduced A New Toy Truck That Was A Hu

Last year, a toy manufacturer introduced a new toy truck that was a huge success. The company invested $2.5 million for a plastic injection molding machine (which can be sold for $2.0 million) and $100,000 in plastic injection molds specifically for the toy (not valuable to anyone else). Labor and the cost of materials necessary to make each truck is about $3. This year, a competitor has developed a similar toy that has significantly reduced demand for the toy truck. Now, the original manufacturer is deciding whether they should continue production of the toy truck. If the estimated demand is 100,000 trucks, what is the break-even price for the toy truck? Should you shut down?

Paper For Above instruction

Introduction

The decision to continue or shut down production of a product hinges critically on understanding the break-even price, especially in a competitive market where demand may fluctuate due to external factors. This analysis examines the costs associated with manufacturing the toy truck and evaluates whether continued production is financially viable at the estimated demand level of 100,000 units. The core objective is to determine the break-even price per unit and provide strategic recommendations based on this analysis.

Understanding Fixed and Variable Costs

In the context of manufacturing, costs are generally classified into fixed and variable categories. Fixed costs are expenses that do not change with the level of production, such as capital investments in machinery and molds. Variable costs fluctuate directly with production volume, including labor and raw materials needed for each unit.

The fixed costs include:

- The investment in the injection molding machine: $2.5 million (potential salvage value of $2.0 million)

- The molds for manufacturing the toy trucks: $100,000

The variable costs include:

- Labor and materials: approximately $3 per truck

To analyze the profitability at the given demand level, the relevant costs are the fixed costs (already incurred or sunk) and the marginal costs associated with producing each unit.

Analysis of Fixed Costs

The initial investment of $2.5 million for the machine represents a significant fixed cost. Since the machine can be sold for $2 million, this suggests a potential salvage value, which effectively reduces the net fixed cost if the company considers selling the machinery instead of continuing production. If the equipment continues to be used for production, the sunk cost remains, but for decision-making purposes, only the additional costs need to be considered.

The molds costing $100,000 are specific to this product and are also fixed costs that have been incurred. They are sunk costs if they cannot be repurposed or reused for other products.

Given these fixed costs, the question becomes: at what price per unit does the company cover these fixed costs plus the variable costs, considering the demand of 100,000 units?

Calculation of Break-Even Price

The break-even point occurs where total revenue equals total costs.

Total variable costs (TVC):

- $3 per truck * 100,000 trucks = $300,000

Total fixed costs (TFC):

- Investment in machinery: $2.5 million

- Molds: $100,000

- Total fixed costs: $2,500,000 + $100,000 = $2,600,000

However, in practical decision-making, the machinery's book value or salvage value impacts the net fixed costs. If the company considers selling the machine at $2 million, it can decrement the fixed costs by this amount, effectively reducing the fixed costs to:

- $2,600,000 - $2,000,000 = $600,000

But because the initial investment is a sunk cost, the relevant fixed costs for the break-even analysis are the costs directly related to production, which are primarily the mold amortization and related fixed expenses. For simplicity, and reflecting typical managerial decision-making, fixed costs are often considered without salvage value adjustments unless the machinery's sale proceeds impact short-term cash flow.

Thus, the break-even price per unit (P) satisfies:

P * 100,000 = Fixed costs + Variable costs

P * 100,000 = $2,600,000 + $300,000

P * 100,000 = $2,900,000

P = $2,900,000 / 100,000

P = $29

Therefore, the break-even price for each toy truck must be at least $29 to cover all fixed and variable costs at this demand level.

Should Production Continue?

If the market price for the toy truck falls below $29, the company will incur losses on each additional unit sold, and it might be more economically feasible to cease production, especially if fixed costs cannot be recovered.

Given the reduction in demand caused by the competitor's newer product, it is essential to assess whether the current or expected market price for the toy truck can sustain a price at or above $29. If market prices are significantly lower, continuing production might not be prudent unless strategic reasons, such as maintaining market presence or brand loyalty, justify the loss.

Furthermore, considering the sunk nature of the fixed costs and the potential to sell the machinery for $2 million, the company might consider shutting down in the short term to avoid further losses, especially if demand is expected to decline further.

Conclusion

The analysis indicates that to break even at an estimated demand of 100,000 trucks, the toy manufacturer must set a price of at least $29 per unit. If market prices are below this threshold, maintaining production would result in losses, and shutting down would be advisable unless strategic considerations intervene. The decision hinges on the current and projected market prices and whether the firm values long-term strategic positioning over short-term profitability. If the market price remains below the break-even point, ceasing production temporarily or permanently may maximize the firm’s financial health.

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