“In my opinion, it will be a mistake if the new plant is built,” said Steven Webber, controller of Tanka Toys.

ACCOUNTING 203 (chapter 5,6,7)

“In my opinion, it will be a mistake if the new plant is built,” said Steven Webber, controller of Tanka Toys. “Why, if that plant was in existence right now, we would be reporting a loss of $100,000 for the year 2014 rather than a profit, and 2014 sales have been the best in the history of the company.

Mr. Webber 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:

Year	Sales	Income as a percent of sales
2008	$ 800,000	7.4
2009	1,900,000	7.0
2010	2,600,000	6.1
2011	3,000,000	5.3
2012	2,400,000	1.2
2013	3,700,000	3.8
2014	4,000,000	3.0

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 2007, 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 percent 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. Other toy manufacturers produce evenly during the year, thereby maintaining a stable work force. Carrie Russell, 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 Kayla Dernier, head of the company’s new products department. Kayla 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 the 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 2012, causing a 20 percent drop in sales and a sharp drop in profits, as shown 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. Webber points out that although variable costs will be reduced by the new plant, fixed costs will rise steeply, to $1,700,000 per year. On the other hand, fixed costs are now $450,000 per year. Mr. Webber is confident (and Ms. Russell agrees) that with stringent cost controls variable expenses can be held to 82 percent of sales if the company continues with it present production setup. Variable expenses will be 60 percent of sales if the new plant is built.

Ms. Russell 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 percent 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 break-even point in sales dollars (2.5 pts.)

b. Prepare a contribution format Income Statement for each of the next three years (2015 – 2017) using projected sales as follows (these figures assume a 10 percent growth rate in sales each year): (5 pts.)

Year	Sales
2015	$ 4,400,000
2016	4,840,000
2017	5,324,000

Assume that cost behavior patterns remain stable over the three-year period.

c. Refer to the computations in (b) above. Compute the operating leverage and the margin of safety percentage for each year. (2.5 pts.)

2. Assuming that the company builds the new plant, redo the computations in (1)(a), (1)(b), and (1)(c) above. Use projected sales as follows (these figures assume a 15 percent growth rate in sales each year): (10 pts.)

Year	Sales
2015	$ 4,600,000
2016	5,290,000
2017	6,083,500

3. Refer to the original data. Assume that Tanka Toys “misses the market” with its toy lines in 2015 and that sales fall by 20 percent to only $3,200,000 for the year. Compute the net profit or loss for the year with or without the new plant. (5 pts.)

4. Refer to the original data. Suppose that the company is anxious to earn a target profit of at least 12 percent on sales.

a. At what sales level will the 12 percent target profit on sales be achieved if the new plant is built? According to the company’s projected sales growth, in what year will this sales level be reached? (2.5 pts.)

b. At what sales level will the 12 percent target profit on sales be achieved if the company keeps its old plant? How long does it appear that it will take the company to reach this sales level? (2.5 pts.)