Question

Janet Gilbert is director of a lab. She has some extra capac- ity and has contracted with some small neighboring hospitals to run some of their lab tests. She has recently had a study conducted and has determined that her costs for these contracts are $50,000, of which $7,000 is the variable cost of supplies. The rest is non- avoidable fixed cost. She currently charges an average of $30 per test. She is thinking of lowering her price by 20 percent in hopes of raising her current volume of 20,000 tests by 25 percent. If she does so, she expects her variable cost per test will go up by 5 percent. Determine the current and predicted (a) revenues, (b) variable costs, and (c) total contribution margin and product margin. What should she be recommended to do

Answer 1

Answer:

A) Current revenues = $600,000

Predicted revenues = $600,000

B) Current variable cost = $7,000

Predicted variable cost = $9187.5

C) Current total contribution margin = $593,000

Predicted total contribution margin = $590,812.5

Current product margin = $550,000

Predicted product margin = $547,812.5

I would recommend that she shouldn't decrease the price.

Explanation:

A) Current revenues = $30 × 20000 tests = $600,000

Predicted revenues; She is thinking of lowering her price by 20 percent and also raising her current volume by 25 percent, thus;

Predicted revenues = (100% - 20%) × $30 × 20000 × (100% + 25%) = $600,000

B) Current variable cost = $7,000

she expects her variable cost per test will go up by 5 percent, thus;

Predicted variable cost = (7000/20000) × (100% + 5%) × 20000 × (100% + 25%) = $9187.5

C) Current total contribution margin = $600000 - $7,000 = $593,000

Predicted total contribution margin = $600000 - $9187.5 = $590,812.5

Fixed cost = $50000 - $7,000 = $43,000

Thus;

Current product margin = $593,000 - $43,000 = $550,000

Predicted product margin = $590,812.5 - $43,000 = $547,812.5

The predicted product margin is lesser than the current one, so my recommendation to her would be that she shouldn't decrease the price. This is because the lower selling price and higher volume does not lead to an increase in the revenue derived from sales, but instead increases the variable costs, which in turn causes a decrease in product margin.