QUALITY IMPROVEMENT AND PROFITABILITY

Reading Company reported the following sales and quality costs for the past four years. Assume that all quality costs are variable and that all changes in the quality cost ratios are due to a quality improvement program.

Year	Sales Revenues	Quality Costs as a Percent of Revenues
1	$10,000,000	21%
2	11,000,000	18
3	11,000,000	14
4	12,000,000	10

Required:

1. Compute the quality costs for all four years. By how much did net income increase from Year 1 to Year 2 because of quality improvements? From Year 2 to Year 3? From Year 3 to Year 4?

2. The management of Reading Company believes it is possible to reduce quality costs to 2.5 percent of sales. Assuming sales will continue at the Year 4 level, calculate the additional profit potential facing Reading. Is the expectation of improving quality and reducing costs to 2.5 percent of sales realistic? Explain.

3. Assume that Reading produces one type of product, which is sold on a bid basis. In Years 1 and 2, the average bid was $200. In Year 1, total variable costs were $125 per unit. In Year 3, competition forced the bid to drop to $190. Compute the total contribution margin in Year 3 assuming the same quality costs as in Year 1. Now, compute the total contribution margin in Year 3 using the actual quality costs for Year 3. What is the increase in profitability resulting from the quality improvements made from Year 1 to Year 3?