Problem 6-19 Basic ofCVP Analysis; Cost structure(Lo1,L03,L04,L05,L06)

Due to erratic sales of it's sole product - a high - capacity battery for labtop computers PEM, Inc., has been experiencing difficulty for some time. The company's contribution format income statement for the most recent month is given below;

Sales (19,500 units x $30 per unit) Variable expenses

Contribution margin

Fixed expenses

Net operating loss

$585,000 409,500 175,500 180,000

$ (4,500)

Required:

1. compute the company's CM ratio and it's break-even point in both units and dollars.

Sales (19,500 units x $30 per unit) Variable expenses

Contribution margin

Fixed expense

Net operating loss

Per unit 30 21

9

$585,000 409,500 175,500 180,000

$( 4,500)

CM ratio CM ratio

Total CM = 175,500 x 100

Total sales 585,000

Each $1.00 increase in sales results in a total contribution margin increase of 30cents

=

=30% -:

In term of units

CM ratio =

UnitCM

Unit selling price

= _..2_ x 100 30

=30%

Break- even point

Break-even point in unit sold

= fixed expenses CM per unit 180,000

9

= 20,000 units

/

Break-even point in total sales dollars

= fixed expenses CMratio

= 180,000

0.3 /

= $600,000

2. The president believes that a $16,000 increase in the monthly advertising budget, combined with an intensified effort by the sales staff, will result in an $80,000 increase in monthly sales. If the president is right, what will be the effect on the company's monthly net operating income or loss? (use the incremental approach in preparing your answer)

Ans

Increase in sales $80,000 x CM ratio (0.3) Increase in advertising expense

Increase in net operating income

$24,000 16,000 8,000

Since now the company shows a loss of$4,500 , If the changes are applied, the loss will turn to a profit of $3,500 ($8,000 - $4,500 = $3,500)

3. refer to the original data. The sales manager is convinced that a 10% reduction in the selling price, combined with an increase of $60,000 in the monthly advertising budget, will cause unit sales to double. What will the new contribution format income statement look like if these changes are adopted?

Ans

Sales (39,000 units x $27) Variable expenses Contribution margin Fixed expense

Net operating income (loss)

$1,053,000 819,000 234,000 240,000 $ (6,000)

/

Net operating income will decrease by $6,000

4. refer to the original data. The Marketing Department thinks that a fancy new package for the laptop computer battery would help sales. The new package would increase packaging costs by 75cents per unit. Assuming no other changes, how many units would have to be sold each month to earn a profit of $9,750?

Ans

Sales 30Q 8.25Q Q

variable expenses + fixed expenses + profits 21.75Q + 180,000 + 9,750

189,750 189,750

8.25

=

=

=

=

23,000 Units

/

5. refer to the original data. By automating certain operations, the company could reduce variable costs by $3 per unit. However, fixed costs would increase by $72,000 each month.

a. compute the new CM ratio and the new break-even point in both units and dollars.

Ans

/

CM ratio

Total CM Total sales

= 234,000 x 100 585,000

=40%

Sales (19,500 units x $30) Variable expense (19,500 x $18) Contribution margin

Fixed expenses

Net operating income CM ratio

585,000 351,000 234,000 252,000 (18,000)

Per unit 30

u

12

Each $1.00 increase in sales results in a total contribution margin increase of 40cents

CM ratio unit =

UnitCM

= _ll_x 100 30

=40%

Unit selling price - Break-even point in unit sold

= fixed eXQenses
CM per unit
= 252,000
12 /
= 21,000 units Break-even point in total sales dollars

= fixed eXQenses CM ratio 252,000 0.4 $630,000

/

b. Assume that the company expects to sell 26,000 units next month.

Prepare two contribution format income statements, one assuming that operations are not automated and one assuming that they are. (Show data on a per unit and percentage basis, as well as in total, for each alternative.

Not automated Automated
Per unit Per unit
Sales (26,000 units x $30) 780,000 30 780,000 30
Variable expenses 546,000 21 468,000 18
Contribution margin 234,000 9 312,000 12
Fixed expenses 180,000 252,000
Net operating income 54,000 60,000 / c. Would you recommend that the company automate its operation" explain.

Ans

If the company decide to automate its operation, obviously CM ratio will be changed from 30% to 40 % . (The higher ratio means than if the breakeven-point is reached, profit will increase more rapidly). The company should tend to increase its sales volume for more profit. If the company's sales volume decreases, loss will be larger than present because of the greater fixed cost.

7,200,000 2,340,000

9,500,000 6,460,000

Problem 6-32 Pittman Company is a small but growing manufacturer of telecommunications equipment. The company has no sales force of its own;rather,it relies completely on independent sales agents to market its products.These agents are paid a commission of 15 % of selling price for all items sold.

Babara Cheney, Pittman's controller has just prepared the company's budgeted income

statement for next year. The statement follows;

Pittman Company Budgeted Income Statement For the Year Ended December 31

Sales Manufacturing costs Variable

Fixed overhead Gross margin

Selling and administrative costs; Commissions to agents

Fixed marketing costs

Fixed administrative costs

Net operating income

Less fixed interest costs Income before income taxes Less income taxes (30%) Net Income

16,000,000

2,400,000 120,000 1,800,000

4,320,000 2,140,000 540,000 1,600,000 480,000 $1,120,000

* Primarily depreciation on storage facilities

As Barbara handed the statement to Karl Vecci, Pittman's president, she commented,

, I went ahead and used the agents' 15% commission rate in completing these statements, but we've just learned that they refuse to handle our products next year unless we increase the commission rate ro 20 % "

" That's the last straw, " Karl replied angrily. "Those agents have been demanding more and more, and this time they've gone too far .How can they possibly defend a 20 % commission rate ?" " They claim that after paying for advertising, travel ,and the other costs of promotion, there's nothing left over for profit, " replied Barbara.

" I say it's just plain robbery ." retoted Karl "And I also it's time we dumped those guys and got our own sales force. Can you get your people to work up some cost figures for us to look at ? "

"We've already worked them up, "said Barbara" Several companies we know about pay

a 7.5 % commission to their own salespeople ,along with a small salary. Of course, we would have to handle all promotion costs, too. We figture our fixed costs would increase by $2,400,000 per year ,but that would be more than offset by the $3,200,000 (20 % * $16,000,000) that we would avoid on agents' commissions"

The breakdown of the $2,400,000 cost follows;

Salaries

Sales manager Salespersons

Travel and entertainment Advertising

Total

$100,000 600,000 400,000 1,300,000 $2,400,000

/

"Super, " replied Karl." And I noticed that the $ 2,400,000 is just what we're paying the agents under the old 15 % commission rate"

"It's even better than that, " explained Barbara. " We can actually save $ 75,000 a year because that's what we're having to pay the auditing firm now to check out the agents's reports. So our overall administrative cost would be less, "

"Pull all of these numbers together and we' llshow them to the executive committee tomorrow," said Karl. "With the approval of the committee, we can move on the matter immediately."

1. Compute Pittman Company's break - even point in sales dollars for next year assuming; a. That the agents' commission rate remains unchanged at 15 %

Break - even point = Fixed Costs CM ratio

Fixed Costs 2,340,0000+ 120,000+ 1,800,000+540,000

$4,800,000

CMratio

contribution margin

Sales

contribution margin = 16,000,000 - ( 7,200,000 + 2,400,000 )

6,400,000

6,400,000 16,000,000

0.4

Break - even point

4,800,000 0.4

$12,000,000

b. That the agents I commission rate is increased to 20 %

Break - even point = Fixed Costs CMratio

Fixed Costs

2,340,0000+ 120,000+ 1,800,000+540,000

$4,800,000

CM ratio contribution margin

Sales

contribution margin = 16,000,000 - (7,200,000 + 3,200,000) ** 16,000,000*20%**

5,600,000

5,600,000 16,000,000 0.35

Break - even point = 4,800,000

0.35 $13,714,286

/

c. That the company employs its own sales force

Break - even point = Fixed Costs CMratio

Fixed Costs

2,340,000+120,000+1,800,000+540,000 + (2,400,000 -75,000)

$7,125,000

CM ratio contribution margin

Sales

contribution margin = 16,000,000 - (7,200,000 + 1,200,000) ** 16,000,000*7.5%**

7,600,000

7,600,000 16,000,000 0.475

Break - even point = 7,125,000

0.475 $15,000,000

/

2. Assume that Pittman Company decides to continue selling throgh agents and pays the 20% commission rate. Determine the volume of sales that would be required to generate the same net income as contained in the budgeted income statement for next year .

Dollar sales to attain target profit =

Fixed expenes + Target profit

CMratio

"Ot1n'iiil 1 (b)

Fixed expenes + Target profit = 4,800,000 + 1,600,000

CM ratio 0.35

Dollar sales to attain target profit = 6,400,000 0.35

$18,285,714

/

3.Determine the volume of sales at which net income would be equal regrardless of whether Pittman Company sells through agents ( at a 20 % commission rate) or employs its own sales force.

x

Sales

Commission 20 %

Sales 16,000,000

Variable expenes + Fixed expenses 10,400,000 + 4,800,000

Variable expenes

10,400,000 By Sales 16,000,000

Variable expenes

0.65 x

x

0.65 x +4,800,000

Own sales force

Sales 16,000,000

Variable expenes + Fixed expenses 8,400,000 + 7,125,000

Variable expenes

8,400,000 By Sales 16,000,000

Variable expenes

0.525 x

x

0.525 x +7,125,000

I

0.125x

2,325,000 2,325,000 0.125

s 18,600,000

0.65x + 4,800,000 = 0.525x+7,125,000

x

x

4.Compute the degree of operating leverage that the company would expect to have on December 31 at the end of next year assuming;

Pittman Company
Budgeted Income Statement
For the Year Ended December 31 15% 20% own sales force
Sales 16,000,000 16,000,000 16,000,000
Manufacturing costs
Variable 7,200,000 7,200,000 7,200,000
Commissions 2,400,000 3,200,000 1,200,000
Total variable 9,600,000 10,400,000 8,400,000
Contribution margin 6,400,000 5,600,000 7,600,000
Fixed marketing costs 120,000 120,000 2,520,000
Fixed administrative costs 1,800,000 1,800,000 1,800,000
Interest 540,000 540,000 540,000
Income before income taxes 1,600,000 800,000 475,000
Less income taxes (30%) 480,000 240,000 142,500
Net Income $1,120,000 560,000 332,500 6,400,000 1,600,000 4

a.That the agents' commission rate remains unchanged at 15 %

DOL Conribution margin

Net operating income

.:

5,600,000 800,000 7

.:

b.That the agents' commission rate is increased to 20 %

DOL Conribution margin

Net operating income

c.That the company employs its own sales force

DOL Conribution margin

Net operating income

7,600,000 475,000 16

5. Based on the data in( 1) through (4) above ,make a recommendation as to whether the company should continue to use sales agents ( at a 20 % commission rate) or employ its own sales force Give reasons for your answer

1::nniiil 1 Flilll!lif'llu 20% 11 ;51"'illYJu ~&hni' own sales force liil $13,714,286 LLiI:: $15,000,000 5l'lIR'~1J

2::nniiil . DOL tlil\l Flilll!liltlu 20 % &hni, own sales force liil 7 LLiI:: 16 5l'lIR'~1J

3.n"fOi,u·uu. ,h'b&qYlB ':nniiil 4 Flilll!liltlu 20 % 11 ti"'&qYlB~i9\1ni' own sales force liil 560,000 LLiI:: 332,500 5l'lIR'~1J