Problem 1
Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for $20 per unit. Variable
expenses are $8 per unit, and fixed expenses total $180,000 per year. Its operating results for last year
were as follows:
Sales $ 400,000
Variable expenses 160,000
Contribution margin 240,000
Fixed expenses 180,000
Net operating income $ 60,000
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Required:
Answer each question independently based on the original data:
1. What is the product’s CM ratio?
CM ratio = (Contribution Margin / Sales) * 100
CM ratio = ($240,000 / $400,000) * 100
CM ratio = 60%
2. Use the CM ratio to determine the break-even point in dollar sales.
Break-even sales = Fixed Expenses / CM ratio
Break-even sales = $180,000 / 0.60
Break-even sales = $300,000
3. If this year’s sales increase by $75,000 and fixed expenses do not change, how much will net
operating income increase?
New Sales = old sales + increase in sales
= $ 400,000 +$ 75,000
= $ 475,000
New Variable cost = New Sales / Selling price per unit
= $ 475,000 / $ 20
= 23,750 units sold
= 23,750 * $ 8 per unit cost (varaible cost per unit)
= $ 190,000
Contribution Margin = sales - variable expenses
= $ 475,000 - $ 190,000
=$ 285,000
Sales $ 475,000
Variable expenses 190,000
Contribution margin $ 285,000
Fixed expenses 180,000
Net operating income $ 105,000 ($ 60,000)
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$ 45,000 (net operating income increase)
0r
Net operating income increase = (Increase in Sales * CM ratio)
Net operating income increase = ($75,000 * 60%)
Net operating income increase = $45,000
4. a. What is the degree of operating leverage based on last year’s sales?
Degree of Operating Leverage (DOL) = (Contribution Margin / Net Operating Income)
DOL = $240,000 / $60,000
DOL = 4
b. Assume the president expects this year’s sales to increase by 20%. Using the degree of operating
leverage from last year, what percentage increase in net operating income will the company realize
this year?
Percentage increase in net operating income = (DOL * Percentage increase in sales)
Percentage increase in net operating income = (4 * 20%)
Percentage increase in net operating income = 80%
5. The sales manager is convinced that a 10% reduction in the selling price, combined with a $30,000
increase in advertising, would increase this year’s unit sales by 25%. If the sales manager is right, what
would be this year’s net operating income if his ideas are implemented? Do you recommend
implementing the sales manager’s suggestions? Why?
Recommendations:
If the company will treat the proposal entirely with the assumption of selling the additional 25%
units, this will give them $ 40,000 of net operating income. Although it is $20,000 behind from the last
years' net operating income, the company might be considering long-term strategy in a way that the
advantage of additional advertising budget and lowering the price will capture more of the market share,
and might attract new customers and/or retain existing ones.
Calculate New Sales with 10% reduction and a $30,000 advertising increase, and 25% units sales increase
New Sales price = $20 * 10%
= $ 18
New Sales = 25,000 * $18
= $ 450,000
New Variable Expenses = 25,000 * $ 8
= $ 200,000
New Contribution Margin = $ 450,000 - $ 200,000
= $ 250,000
New Fixed cost = $ 180,000 + $ 30,000
= $ 210,000
Sales $ 450,000
Variable expenses 200,000
Contribution margin 250,000
Fixed expenses 210,000
Net operating income $ 40,000
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However, if assuming that the company still sold 20,000 units but with lower price and and
additional $ 30,000 for the advertising and see if the sales manager's idea wouls really increase 25% of
the unit sales, the answer is no. As the company will incur a loss, therefore, the idea of the sales
manager is not correct. This idea, if followed, and given the same amount of unit produced and sold last
year will lead to financial stability, even if the the increase of advertising expense will not be effective
since it did not result to the expected out come the sales manager was thinking.
Calculate New Sales with 10% reduction and a $30,000 advertising increase
New Sales price = $20 * 10%
= $ 18
New Sales = 20,000 * $18
= $ 360,000
Variable Expenses = $160,000
New Contribution Margin = $ 360,000 - $ 160,000
= $ 200,000
New Fixed cost = $ 180,000 + $ 30,000
= $ 210,000
Sales $ 360,000
Variable expenses 160,000
Contribution margin 200,000
Fixed expenses 210,000
Net operating income - $ 10,000
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6. The president does not want to change the selling price. Instead, he wants to increase the sales
commission by $1 per unit. He thinks that this move, combined with some increase in advertising,
would increase this year’s sales by 25%. How much could the president increase this year’s advertising
expense and still earn the same $60,000 net operating income as last year?
New Sales = 25,000 * $20
= $ 500,000
New variable costs per unit = 25,000 units * 8
= $ 200,000
Commision cost = $ 25,000
New variable expense = $25,000 + $ 200,000
= $ 225,000
Fixed Cost = $ 180,000
New Contribution Margin = $ 275, 000
New net operating income
Sales $ 500,000
Variable expenses (225,000)
Contribution Margin 275,000
Fixed expenses (180,000)
Net operating income $ 95, 000
Net operating income buffer ( $ 60,000)
Incremental available to spend on advertising $ 35, 000
New variable expense = $20,000 + $ 160,000
= $ 180,000
New Contribution Margin = $ 400,000 - $ 180,000 - $ 60,000
Problem 2
For nearly 20 years, Specialized Coating has provided painting and galvanizing services for manufacturers
in its region. Manufacturers of various metal products have relied on the quality and quick turnaround
time provided by Specialize Coatings and its 20 skilled employees. During the last year, as a result of a
sharp upturn in the economy, the company’s sales have increased by 30% relative to the previous year.
The company has not been able to increase its capacity fast enough, so Specialized Coatings has had to
turn work away because it cannot keep up with customer requests. Top management is considering the
purchase of a sophisticated robotic painting booth. The booth would represent a considerable move in
the direction of automation versus manual labor. If Specialized Coatings purchases the booth, it would
most likely lay off 15 of its skilled painters. To analyse the decision, the company compiled production
information from the most recent year and then prepared a parallel compilation assuming that the
company would purchase the new equipment and lay off the workers. Those data are show below. As
you can see, the company projects that during the last year it would have been far more profitable if its
had used the automated approach.
Current Approach Automated Approach
Sales $2,000,000 $2,000,000
Variable costs 1,500,000 1,000,000
Contribution margin 500,000 1,000,000
Fixed costs 380,000 800,000
Net income $ 120,000 $ 200,000
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Answers:
1. The contribution margin ratio is calculated by dividing the contribution margin by sales.
Current Approach: $500,000 / $2,000,000 = 0.25 or 25%
Automated Approach: $1,000,000 / $2,000,000 = 0.5 or 50%
Interpretation: Since, the contribution margin ratio represents the portion of each sales dollar that
contributes to covering fixed costs and ultimately generateing profit. The automated approach has a
higher contribution margin ratio, indicating an increase of the amount of profit since the company's fixed
cost remains constant. Therfore, the fixed cost is being utilized by allocating the larger portion of
company's sales revenue to covering fixed costs.
2. The break-even point in sales dollars is calculated by dividing fixed costs by the contribution margin
ratio.
Current Approach: $380,000 / 0.25 = $1,520,000
Automated Approach: $800,000 / 0.50 = $1,600,000
Interpretation: The break-even point represents the level of sales at which the company covers all its
costs and doesn't incur a profit or loss. In this case, the current approach has a slightly lower break-even
point, which can give positive return to the company for various reasons:
· First, it requires slightly less in sales to cover costs which implies that company can be less
vulnerable to fluctuations like economic downturns.
· Second, the company can start to generate income sooner after meeting the BEP units.
· Third, it can be good for the financial health of the company since the revenue is not reliant on
selling high sales volumes to sustain itself.
· Lastly, since afteing meeting the BEP that can cover all the costs the company starts gaining
profits, then the company can support it self for expansion and/or save more for future plans.
3. The margin of safety ratio is calculated by dividing the difference between actual sales and the break-
even sales by actual sales.
Current Approach: ($2,000,000 - $1,520,000) / $2,000,000 = 0.24 or 24%
Automated Approach: ($2,000,000 - $1,600,000) / $2,000,000 = 0.20 or 20%
Interpretation: The margin of safety ratio measures how much sales can drop before the company
reaches its break-even point. In this case, the current approach has a higher margin of safety, indicating
it can handle a greater decrease in sales before operating at a loss.
4. The degree of operating leverage is calculated as (Contribution Margin / Net Income). To determine
the impact of a 10% decline in sales on net income, you can use the degree of operating leverage.
Current Approach: ($500,000 / $120,000) = 4.17
Automated Approach: ($1,000,000 / $200,000) = 5.00
If sales decline by 10%:
Current Approach: 10% x 4.17 = 41.7% decline in net income
Automated Approach: 10% x 5.00 = 50% decline in net income
5. To find the sales level at which both approaches yield the same net income:
Current Approach:
Net Income = $120,000 + (0.25 x Sales)
$120,000 + 0.25S = $200,000
0.25S = $80,000
S = $320,000
Automated Approach:
Net Income = $200,000 + (0.50 x Sales)
$200,000 + 0.50S = $120,000
0.50S = -$80,000 (negative because it's less profitable)
S = -$160,000 (This implies the automated approach is less profitable at all sales levels)
6. Considerations for the company:
The decision to transition to automation is multifaceted for Specialized Coating, encompassing various
critical factors. Ethical concerns can emerge as layoffs of 15 skilled painters may weaken trust and morale
among remaining employees, potentially leading to increased turnover, since it might cause for more
employees resignation. The substantial upfront investment and ongoing maintenance costs associated
with a robotic painting booth must be carefully weighed against the company's financial stability.
Assessing the stability of increased sales stemming from recent economic upturns is crucial, especially in
the face of potential competition in automation. Long-term strategic objectives come into play as the
decision must align with whether the company aims to become an industry leader through automation
or cherishes its skilled workforce and personal customer relationships. Flexibility is another concern, as
automation may excel in efficiency but fall short in handling custom orders or products requiring a
human touch. Evaluating the impact on customer relationships is paramount, considering some clients'
preferences for skilled painters based on trust and quality. Additionally, the implementation of
automation necessitates training for remaining employees and may result in transitional disruptions that
could affect customer satisfaction and sales. Thus, making an informed choice about the transition to
automation requires a thorough cost-benefit analysis and careful consideration of its broader
implications.
