Chester Case

With Patio, expected sales increase is $10,000 per week. As shown in income statement, Profit before fixed cost increases $11,819 to $15,449 per week. Company invests heavily in Patio so it has to take depreciation into account. Also, company has to pay interest on loan. Depreciation and interest are additional fixed costs. Treatment of Depreciation and Interest: Depreciation and Interest should be treated as fixed cost as they are independent of Sales volume. As calculated in Working Sheet, Weekly Depreciation stand at $236 in first year and weekly interest is $101 per week. Calculation of Break Even Point in Sales: Fixed Cost (FC) = $18,864 + $4,622 = $23,486 Variable Cost (VC) = $49,161 - $4,622 = $44,539 (Controllable, Interest and depreciations are fixed costs. Variable costs are: Total cost of sales, Labor and Marketing) With Patio, Sales = $64,618 Let selling price is $1 per unit . then for a sales of $64,618 Chester's Place is selling 64,618 units Per unit VC = 44539/64618 = $0.6893 Break Even = FC / (SP VC) = $23,486 / ($1 - $0.6893) = 75,590 units Thus, Break Even Sales =75,590 * $1 = $75,590 How to fund Capital Shortfall: For Patio, additional cost Chester has to bear as Patio cost = $64,900 Partners have arranged a loan of $50,000 Capital shortfall = $64,900 - $50,000 = $14,900 In their existing business, they are making a profit of $11,819 per week before other fixed costs. Constructor has told the partners that it will take one month to finish the Patio work. In one month, Chester's Place will make $42,276 as Profit before other fixed costs.This profit can be used to fund Patio Cost. Recommendations: In their present business, Chester's Place is making a profit of $11,819 per week before other fixed costs. After addition of Patio, their profit before other fixed cost will go up. Following table will help in comparing the profit in various cases. Existing Business With Patio- As forecasted With Patio- Optimistic Scenario With Patio- Pessimistic Scenario Profit before other fixed costs $11,819 $15,449 $17,313 $13,584 As % of sales 21.64% 23.91% 24.87% 22.79% Net Profit ($6,641) ($3,415) ($1,551) ($5,280) As shown in table, with the addition of Patio, Profit before other fixed costs increases even in pessimistic scenario (when sales is up by only 50% of the forecasted sales). Even profit before other fixed costs as a percentage of sales improves in pessimistic scenario too. When we take into account the depreciation , other fixed costs and interest, we see that company is not breaking even. But as compared to the present situation, net loss comes down. Though to break even , Chester's Place has to achieve sales of $75,590 per week which is more than its optimistic scenario sales (which stands at $69,618). But, we see that addition of Patio contributes positively and contribution margin goes up even in pessimistic scenario. So, partners should go for Patio