Question

Just Pen Ltd is a company producing and selling pens. The general manager is trying to increase sales by proposing a new advertising strategy, which will increase fixed costs by $50,000 in addition to the $300,000 currently spent. In addition, the manager is also convinced that a 5% cut in selling price (from $20 to $19) will boost sales volume from 40,000 to 50,000 pens. Variable cost will remain at $10 per pen. The managing director has asked you as the company’s accountant to evaluate what impact these changes will have on the contribution margin and margin of safety.

1. Calculate the current contribution margin ratio (%).

2.Calculate the contribution margin ratio if the manager’s ideas are used (%, rounded to 2 decimal places).

3.Calculate the current margin of safety in units.

4.Calculate the margin of safety in units if the manager’s ideas are used.     

Answer 1

Current Contribution margin Income Statement:

	Amount per unit (In $)	Amount (In $)
Sales (40,000 units X $ 20 per unit)	20.00	800,000
Less: Variable Costs (40,000 Units X $ 10 per unit)	10.00	400,000
Contribution margin	10.00	400,000
Less: Fixed Costs		300,000
Net Operating Income		100,000

Answer 1)

Calculation of Current Contribution Margin Ratio

Contribution margin ratio = Contribution margin/ Sales

                                                = $ 400,000/ $ 800,000

                                                = 50%

Answer 3)

Calculation of Current Margin of Safety

Current Margin of safety (In units) = Current Sales level (in units) – Current break-even point sales (in units)

                                                                  = 40,000 units – 30,000 units

                                                                  = 10,000 units

Therefore current Margin of Safety is 10,000 units

Working Note:

Calculation of Current Break-even point of Sales (In Units)

Break-even point of sales (In units) = Total fixed cost/ Contribution margin per unit

                                                                 = $ 300,000/ $ 10 per unit

                                                                 = 30,000 units

Therefore current break-even point of sales is 30,000 units

Proposed Contribution margin Income Statement:

		Amount (In $)
Sales (50,000 units X $ 19 per unit)	19.00	950,000
Less: Variable Costs (50,000 Units X $ 10 per unit)	10.00	500,000
Contribution margin	9.00	450,000
Less: Fixed Costs   ($ 300,000 + $ 50,000)		350,000
Net Operating Income		100,000

Answer 2)

Calculation of Proposed Contribution Margin Ratio

Contribution margin ratio = Contribution margin/ Sales

                                                = $ 450,000/ $ 950,000

                                                = 47.37%

Therefore proposed contribution Margin ratio is 47.37%

Answer 4)

Calculation of Proposed Margin of Safety

Proposed Margin of safety (In units) = Proposed Sales level (in units) – Proposed break-even point sales (in units)

                                                                  = 50,000 units – 38,889 units

                                                                  = 11,111 units

Therefore proposed Margin of Safety is 11,111 units

Working Note:

Calculation of Proposed Break-even point of Sales (In Units)

Break-even point of sales (In units) = Total fixed cost/ Contribution margin per unit

                                                                 = $ 350,000/ $ 9 per unit

                                                                 = 38,889 units

Therefore proposed break-even point of sales is 38,889 units