The company has been producing cars for the Australian market for over 30 years and began exporting a limited number of cars to the United States about 10 years ago. MML is a subsidiary of a Polish multinational that has not been satisfied with the losses that the company has been making in the last few years. The parent company in Poland is threatening to close the Australian factory unless MML can produce a profit in the next year of operations. The factory currently has a capacity to produce 50,000 cars per year but all realistic estimates of its market size, including the exports to the United States, suggest that it will not sell more than 30,000 cars per year in any of the next 5 years.
Jane Woodall, MML’s CEO, was very concerned about MML’s poor profitability. She asked Lester Bush, financial controller and Max Lemond, production manager, to see if there were ways to reduce costs and improve profitability.
Lester analysed the cost structure of MML and found the following:
Variable cost- $15,000 per car
Fixed cost- $450,000,000 for 30,000 cars, or $15,000 per car
Selling and administrative expenses: Variable cost- $5,000 per car
Fixed cost- $180,000,000
During the year end 30 June 2017, MML sold 28,000 Moveover Magnets for $40,000 each.
Lester considered the fact that the capacity of the factory significantly exceeds the production levels and realised that significant savings could be made in both the production and administrative fixed expenses if some of the factory were disposed of. He estimated that by reducing the capacity to 30,000 cars per year, the fixed manufacturing costs would fall to $300 million and the fixed administrative costs would decrease to $160 million.
Before Lester could report back to Jane, Max returned with a proposal to reduce the variable costs to 30% of revenues by reducing the costs MML incurred for safe disposal of wasted metals. Lester was concerned that this would expose the company to potential environmental liabilities and he let Max know it.
Lester: Max, we would need to estimate the potential environmental costs and include them in your Analysis.
Max: You can’t do that. We are not violating any laws. There is some possibility that we may have to incur environmental costs in the future, but if we bring it up now, this proposal will not go through because our senior management always assumes these costs to be larger than they turn out to be. The market is tough, and we are in danger of shutting down the company. I don’t want all my colleagues to lose their jobs. The only reason our competitors are making money is because they are doing exactly what I am proposing…
Source: Hoggett, H. Edwards, L. Medlin, J. and Tilling, M. 2008. Accounting. Wiley: Queensland.
1. Using the information provided by Lester
a) Prepare an income statement for the year ended 30 June 2017 showing contribution margin. b) What is the company’s break-even point in cars? in sales dollars? Is this more or less than the
maximum size of the market for the Moveover Magnet?
c) Should some of the factory be disposed of and would this achieve the profits demanded by the parent
company? What other factors should be considered?
2. Using the information proposed by Max
a) Calculate the company’s break-even point in sales dollars if variable costs are 30% of revenues.
b) Calculate the company’s profit for the year ended 30 June 2017 if total variable costs had been 30%
3. Discuss the ethical issues involved
Who are the stakeholders?
Is the production manager, Max, acting ethically? Which of the principles set out in the Code of
Ethics for Professional Accountants have been violated?
What are Lester’s ethical obligations?
What should Lester do? Critically evaluate each course of action.
4. Make recommendations for improving the profitability of Moveover Magnets.