[SOLVED] The Managing Director of the Kiddy Toy

The Managing Director of the Kiddy Toy Company (KTC) needs to decide whether a special export order should be accepted or rejected, with reasons provided, for the manufacture of Panda bears.
The background
Official statistics indicate that China manufactures and exports about 70 percent of the world’s toys! Not surprisingly, children’s safety is an important issue for toy manufacturers in China and current legislation bans the sale of toys that fail to pass a national compulsory safety certification. For example, toys that “could have a direct effect of the safety of babies and children” have to bear the mark CCC (China Compulsory Certification) and the Certification and Accreditation Administration (CAA) before they can be sold. This certification was introduced shortly after both the EU and the US Consumer Product Safety Commissions had issued safety warnings about many toys made in China.
The Kiddy Toy Company, located in Shanghai, manufactures a range of toys, and one of its best sellers is a small, soft Panda bear, typically in black and white colours, holding a small Chinese flag. Currently, all of the company’s output is sold to various retail outlets in China and the company is operating at 80% capacity, i.e. 500,000 units per annum. Demand each month is relatively constant and there is no significant seasonal trend.
The Financials
The management of the Kiddy Toy Company has been approached by a large retail chain in Boston, which is one of the leading and biggest department stores in the US. This enquiry was the result of a recent promotional visit by the Kiddy Toy Company’s directors to the US and the travel and entertainment expenditure, amounting to $50,000, was considered as money well spent. The US department store has now offered to buy Panda toys with appropriate adaptations for the American culture and it urgently needs 40,000 toys to meet commitments for its Christmas trade. The US retail chain is initially offering to pay $22 each for the toys, together with all the transport costs from Shanghai to the US.
The US retail chain offer does not look attractive to the management of The Kiddy Toy Company. The cost accountant has estimated, based on an annual production of 500,000 Panda bears, the unit cost and selling price to be as follows (Exhibit 1):
Exhibit 1 – Cost per unit (based on a standard product)

Direct materials …………………………………………………………………………… $5.00
Direct labour (variable …………………………………………………………………… 6.00
Production overhead (30 minutes per unit) ……………………………………… 9.00
Production cost (per unit) ……………………………………………………………… 20.00
Non-production costs (40% on cost) ………………………………………………… 8.00
Total cost (per unit) ……………………………………………………………………… 28.00
Mark-up on cost (25%) …………………………………………………………………… 7.00
Normal selling price ……………………………………………………………………… 35.00

In explaining his above calculation, the management accountant of Kiddy Toys Company confirms that it is usual costing practice in the company to assign production overhead to products at the rate of $18 per direct labour hour (based on annual output of 500,000 units) which comprises the following components (Exhibit 2):
Exhibit 2 – Production overhead absorption rate

Variable production overhead ………………………………………………………………… $6.00
Fixed production overhead ……………………………………………………………………… 12.00
OHAR per direct labour hour (60 minutes) ……………………………………………… 18.00

In addition, the cost accountant further explains that the mark-up on production cost (40%) is sufficient to recover all non-production overhead costs. However, included in his estimate of these non-production costs is the sales commission expense, which is based on 10% of the selling price of $35 per unit. It is company policy to always pay this rate of sales commission to its sales agents and this will be the case for this special order, if accepted. Apart from sales commission, all these non-production costs are considered “fixed” in relation to volume changes within a relevant range of activity. Finally, in determining its selling price, the company normally adds a 25% mark-up on total unit cost for a required profit margin. This usual “cost plus” approach to pricing gives an estimated selling price of $35, which is well in excess of the price of $22 per unit which the US retail chain has initially offered.
The managing director of Kiddy Toys Company, a recent MBA graduate, is very interested in obtaining this order as it represents the first opportunity for his Company in the important US market. Consequently, he is anxious to accept the order. However, he realizes that his Company will have to reschedule some existing commitments to other customers and this will result in lost (future) sales during the production of the US order. His best estimate is that this potential loss of custom will reduce his operating cash inflow by $12,000 per month for each of the four months of this proposed contract.
In addition, it was acknowledged that that the US order would require additional costs, over and above the standard product estimate produced by the cost accountant. For example, the US order will require production employees to work only at week-ends and this will require an overtime premium of 20 per cent over and above the basic pay rates. Also, in terms of administration, the order would require additional support costs of $14,000 per month, mainly in terms of complying with higher safety standards and export/import documentation. Furthermore, this special order involves hand-stitching a special American Eagle to each Panda Bear, rather than a Chinese flag, and this additional activity is estimated to increase the direct material cost of $5.00 by $1.00 per unit. If management accepts the order, 10,000 soft toys will be manufactured and shipped to the US chain each month for the next four months. The monthly shipping cost of $20,000 will be paid by the US chain.
The Decision
The managing director was not particularly good at management accounting during his MBA studies. He now realizes that he should have paid more attention and asks you for assistance in this very important, strategic decision for the Company. The decision was simple: whether or not to accept the US offer of $22 per Panda. However, the company was also interested in entering the European market and their market research indicates that the “Chinese Panda bear” is most popular as a toy for small children.

Requirements:

1. Draft a properly formatted memo (about 1- 2 pages) to the Managing Director of the Kiddy Toy Company (KTC) indicating, in relation to the European Market whether the company should compete on the basis of cost leadership or product differentiation.
• Distinguish between product differentiation and a cost leadership strategies
2. Using the normal total cost figure provided and assuming a constant unit selling price of
$35 per unit, clearly present your calculations of the annual break-even point (in units) of the factory (excluding any consideration of the American or European market). Explain some of the major limitations of your calculations.
• Apply basic profit planning (CVP) techniques
3. Clearly present a schedule of “total relevant costs” for the US order offer and indicate whether the price of $22 per unit should be accepted, assuming that commission at the rate of 10% will be paid to agents, based on the selling price offered.
• Explain the concept of relevant cost information with reference to incremental, out of pocket cash costs, opportunity costs and sunk/committed costs.
• Derive selling prices using cost information
4. Briefly explain five important factors, other than price, that the Kiddy Toy Company should consider before finalizing the US order, based on (3) above.
• Identify non-quantifiable (qualitative) factors in specific decision situations
5. Draft a note (about 1 – 2 pages) outlining the advantages and disadvantages of cost-plus pricing.
• Derive selling prices using cost information
• Identify non-quantifiable (qualitative) factors in specific decision situations
• Explain the limitations of using only cost information in selling price decisions

Question: The Managing Director of the Kiddy Toy

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