Reference no: EM13569547

This case concerns the restaurant owner who has the good idea of putting a rack of peanuts at one end of his counter. The idea being that customers would make impulse purchases of these peanuts when they are standing at the counter paying their bill, ordering a drink ... at least, he thought it was a good idea!

EFFICIENCY EXPERT: Joe, you said you put in these peanuts because some people ask for them, but do you realize what this rack of peanuts is costing you?

JOE: It ain't gonna cost. 'sgonna be a profit. Sure, I paid $50 for a fancy rack to hold bags, but the peanuts cost 35 cents a bag and I sell 'em for 50 cents. If I sell 50 bags a week to start it'll take a few weeks to cover the cost of the rack. After that I gotta clear profit of 15 cents a bag. The more I sell, the more I make.

EFFICIENCY EXPERT: That is an antiquated and completely unrealistic approach, Joe. Fortunately, modern accounting procedures permit a more accurate picture which reveals the complexities involved.

JOE: Huh?

EFFICIENCY EXPERT: To be precise, those peanuts must be integrated into your entire operation and be allocated their appropriate share of business overhead. They must share a proportionate part of your expenditure for rent heat, light, equipment deprecation, decorating, salaries for your waitresses, cook......

JOE: The cook? What's he gotta do with peanuts? He don't even know I got 'em.

EFFICIENCY EXPERT: Look Joe the cook is in the kitchen, the kitchen prepares the food, the food is what brings people in here, and the people ask to buy peanuts. That's why you must charge a portion of the cook's wages, as well as part of your own salary to peanut sales. This sheet contains a carefully calculated cost analysis which indicates the peanut operation should pay exactly $2,550 per year toward these general overhead costs.

JOE: The peanuts? $2,550 a year for overhead? The nuts?

EFFICIENCY EXPERT: It's really a little more than that. You also spend money each week to have the windows washed, to have the windows washed, to have the place swept out in the mornings, keep soap in the washroom, and provide free cokes to the police. That raises the total to $2,780 per year.

JOE: [Thoughtfully] But the peanut salesman said I'd make money ..... put 'em on the end of the counter, he said ... and get 15 cents a bag profit.

EFFICIENCY EXPERT: [With a sniff] He's not an accountant. Do you actually know what the portion of the counter occupied by the peanut rack is worth to you?

JOE: Ain't worth nothing - no stool there ... Just a dead spot at the end.

EFFICIENCY EXPERT: The modern cost picture permits no dead spots. Your counter contains 60 square feet and your counter business grosses $45,000 a year. Consequently, the cost of a square foot of space occupied by the peanut rack is $750 per year. Since you have taken that area away the general counter use, you must charge the value of the space to the occupant.

JOE: You mean I gotta add $750 a year more to the peanuts?

EFFICIENCY EXPERT: Right. That raises their share of the general operating costs to a grand total of $3,530 per year. Now then, if you sell 50 bags of peanuts per week, these allocated costs will amount to $1.36 per bag.

JOE: What?

EFFICIENCY EXPERT: Obviously, to that must be added your purchase price of 35 cents per bag, which brings the total to $1.71. So you see by selling peanuts at 50 cents per bag, you are losing $1.21 on every sale.

JOE: Somethin's crazy!

EFFICIENCY EXPERT: Not at all! Here are the figures. They prove your peanuts operation cannot stand on its own feet.

JOE: [Brightening] Suppose I sell lotsa peanuts ... thousands bags a week instead of fifty.

EFFICIENCY EXPERT: [Tolerantly] Joe, you don't understand the problem. If the volume of peanuts sales increases, our operating costs will go up... you'll have to handle more bags with more time, more depreciation, more everything. The basic principal of accounting is firm on that subject: "The Bigger the Operation, the More General Overhead Costs That Must be Allocated." No, increasing the volume of sales won't help.

JOE Okay, you're so smart, you tell me what I gotta do.

EFFICIENCY EXPERT: [Condescendingly] Well .... you could first reduce operating expenses.

JOE: How?

EFFICIENCY EXPERT: Move to a building with cheaper rent. Cut salaries. Wash the windows bi weekly. have the floor swept only on Thursday. Remove the soap from the washrooms. Decrease the square-foot value of your counter. For example, if you can cut your expenses 50%, that will reduce the amount allocated to peanut from $3,530 to $1,765 per year, reducing the cost to $1.03 cents per bag.

JOE: [Slowly] That's better?

EFFICIENCY EXPERT: Much, much better. However,even then you would lose 53 cents per bag if you only charge 50 cents. Therefore, you must raise your selling price. If you want a net profit of 15 cents per bag you would have a charge $1.18.

JOE: [Flabbergasted] You mean even after I cut operating costs 50% I still gotta charge $1.18 for a 50 cent bag of peanuts? Nobody's that nuts about nuts! who'd buy 'em?

EFFICIENCY EXPERT: That's a secondary consideration. The point is, at $1.18 you'd be selling at a price based upon a true and fair evaluation of your then reduced costs.

JOE: [Eagerly] Look! I gotta better idea. Why don't I just throw the nuts out ... put 'em in the garbage.

EFFICIENCY EXPERT: Can you afford it?

JOE: Sure. All I got is about 50 bags of peanuts ... cost about $17.... so I lose $50 on the rack, but I get outta this nutty business and no so more grief.

EFFICIENCY EXPERT: [Shaking head] Joe it isn't that simple. You are in peanut business! The minute you throw those peanuts out you are adding $3,530 of annual overhead to the rest of your operation. Joe ... be realistic... can you afford to do that?

JOE: [Completely crushed] It's unbelievable! last week I was making money. Now I'm in trouble ... just because I believe 50 bags of peanuts a week is easy.

EFFICIENCY EXPERT: [With raised eyebrow] that is the object of modern cost studies, Joe ... to dispel those false illusions.

REQUIRED

1. Is Joe losing $1.21 on every sale of peanuts? Explain.

2. Do you agree that if the volume of peanut sales is increased, operating losses will increase? Explain.

3. Do you agree with the "Efficiency Expert" that, in order to make peanut operation profitable, the operating costs in the restaurant should be decreased and selling price of the peanuts should be increased? Give reasons.

4. Do you think that Joe should eliminate his peanut operations? Why or why not?