Question

You are the owner of a parasailing company that is expanding operations to a new beachfront location, and you need to prepare a 3-year analysis for the bank that may loan you the funds to purchase your boat and parasailing equipment. A lot of business is done on a referral basis, where a company pays a fee to a 3rd party to send them customers. However, because of your well-established reputation, you already have received requests for “flights” to be scheduled as soon as you open the new location. Therefore, you expect to break-even the first year but must calculate the number of flights needed. You also need to determine the new break-even point in Year 2 if the location allows referrals, which you believe will cost on average about 2% of the sales price overall. Finally, you need to determine the volume needed to have $10,000 in profit in Year 3. The following information is available:

• Sales price per flight $175
• Estimated loan payment per month $350
• Fuel costs per flight $100
• Full-time scheduler salary $2,500 per month
• Boat crew per flight $30
• $500 per month dock fee and use of a small office on a pier

Requirements:

• Calculate the Year 1 break-even quantity, contribution margin, and contribution margin ratio. Explain how the values were determined.
• Calculate the Year 2 break-even quantity, break-even sales, and contribution margin ratio. Explain how the values were determined.
• Determine the number of flights (units) needed to retain a profit of $10,000 in Year 3, assuming the company does allow for referrals.
• Recommend if the bank should issue the loan.

Superior papers will:

• Perform all calculations correctly.
• Articulate the approach to solving the problem.
• Explain the relationship of the costs to the concept of contribution margin.
• Discuss any limitations of the data, including what may be missing.
• Conclude on whether the bank should issue the loan

I have done all the calculation but I need only an explanation for these two questions

Explain the relationship of the costs to the concept of contribution margin?

Discuss any limitations of the data, including what may be missing.

Thanks in advance,

Answer 1

1. Explain the relationship of the costs to the concept of contribution margin?

Answer: There is a relationship between variable cost and contribution margin.

Contribution margin is calculated by sales revenues minus variable costs and represents the profit which is generated for each product or unit sold. This can be measured as a percentage or as a dollar figure. One of the most important factors of contribution margin is that it remains fixed on a per unit basis and does not depend on the number of units manufactured or sold. It is because only variable costs change based on units of production, fixed costs have no direct impact on contribution margin. Items such as components and materials used for production can be purchased in larger quantities in order to reduce base unit costs and increase the final number of units produced. As these variable costs go down the contribution margin on the final product will increase.

2. Discuss any limitations of the data, including what may be missing.

Answer: There are certain limitations of the data. Due to the number of data estimations required to calculate, it can lack accuracy and should be considered an approximation instead of a guarantee. For example, CVP assumes that both total costs and total sales are linear but we know that scales of economy can impact costs and large purchases may lead to a decrease in cost per unit which wouldn’t be represented in the analysis. Another assumption made which can change dramatically depending on external factors is the demand for the provided service. Demand can be forecast to some extent but this can add another estimation to the analysis which can easily change.

Several other fixed costs pertaining to any business is missing from the provided date. Tax payments are a significant component of fixed costs which should be considered. If taxes aren’t added to the calculation we can only assume the fixed price would rise and our analysis would have to be re-done in order for it to be more accurate.

The client data suggests that the tents and other structures as well as trucks and vehicles are only “allocated costs” and not actual costs. Even though these are considered fixed costs, circumstances can change, and these allocated costs may increase or decrease dramatically. For example, a rise in fuel costs will increase the allocated costs of trucks and vehicles.

Other missing variables specific to this example include fixed costs office rent and storage costs as well as the variable cost of utilities. All of which should be recorded and added to your costing plan. Without these added into your CVP it will give an inaccurate representation of your breakeven point and you could end up losing money.