Question

Introduction: Having the ability to effectively communicate is one of the most important skills a business executive can possess. As French businesswoman and author Mirelle Guilliano has said, “Intelligence, knowledge or experience are important and might get you a job, but strong communication skills are what will get you promoted.” My own business experience supports this statement. By the time individuals have a few years of experience, they have great technical skills and can assemble, analyze, and categorize data to make solid business decisions. In the end, however, they are often unable to communicate the results of their analysis effectively. When I speak to senior executives and inquire about educational needs, the conversation invariably turns to communications. In accounting, by necessity, we focus on financial and quantitative data, but it is important to remember that as accountants we must be able to present the results of our analysis or studies to management. Through effective communications, accountants can truly impact business decisions and make their careers soar. The best way to get better at anything is to practice. That’s the basis for this assignment – to practice written communication.

Situation for Analysis: Grayslake Novelty produces and sells a small novelty item through tourist shops in Chicago and other northern Illinois locations. Last year the company sold 198,400 units. The income statement for Grayslake Novelty for last year is shown below:

Sales

$992,000

Less: Variable Expenses

545,600

Contribution Margin

446,400

Less: Fixed Costs

180,000

Net Operating Income

$266,400

While the company has been profitable, as shown in the above income statement, sales began falling near the end of last year and have continued to decline this year. There is concern that new competitors are beginning to take market share from Grayslake Novelty. As a result, Sarah Burroughs, the company president, has asked you to provide some information to assist her in making decisions about the company’s strategy for this product. These alternatives should be evaluated individually as stated. You are free and encouraged to offer your own alternative based on any of the parameters given in the data.

Required:

a. While the company is currently profitable, the president wants to know the contribution margin and the breakeven in both units and dollars using last year’s level of sales. Additionally, compute the margin of safety, margin of safety ratio, and degree of operating leverage based on last year’s sales.

b. One of the possible strategies (Alt 1) is to reduce the current price by 8%. Using last year’s level of sales, what is the new contribution margin and break-even in units and dollars based on the price reduction? Additionally, compute the margin of safety, margin of safety ratio, and degree of operating leverage based on last year’s sales.

c. A second strategy (Alt 2) is to reduce the current variable cost by 0.20 per unit. The company has identified available efficiencies that can be implemented without any additional changes to the current cost. What is the new contribution margin and break-even in units and dollars based on the variable cost reduction of 0.20 per unit? Additionally, compute the margin of safety, margin of safety ratio, and degree of operating leverage based on last year’s sales.

d. A third strategy (Alt3) is to decrease the current price by 8% and reduce the variable cost per unit by 0.20. What is the new contribution margin and break-even in units and dollars based on making both changes? Additionally, compute the margin of safety, margin of safety ratio, and degree of operating leverage based on last year’s sales.

e. A fourth strategy (Alt 4) under consideration is to invest in more automated equipment for the manufacturing process. This investment will reduce variable costs by 0.65 per unit, primarily reducing the direct labor. At the same time, this will increase the fixed costs by $50,000. What is the new contribution margin and break-even in units and dollars based on this change in operating structure? Additionally, compute the margin of safety, margin of safety ratio, and degree of operating leverage based on last year’s sales.

f. A final strategy (Alt 5) is to change the current structure for the company’s sales person. The current fixed cost includes the salary of Grayslake’s one sales person at $60,000 per year. The company’s marketing study suggests that sales could be increased by 20% if the company hired an additional sales person; paid both individuals $40,000 fixed salaries; and a 0.25 commission per unit sold. What is the new contribution margin and break-even in units and dollars based on this change? Additionally, compute the margin of safety, margin of safety ratio, and degree of operating leverage based on last year’s sales as the starting point for this change.

Submission Instructions:

Write a business memo addressed to the president recommending the best course of action based on your analysis. In your memo, discuss changes in break-even points, and impacts to the operating leverage. The company’s long-range plan is to grow sales to 250,000 units in the next two to three years. In your memo, summarize the advantages and disadvantages of each of the alternatives. Critically evaluate the alternatives based on current market conditions and any impact each alternative may have on the long-range plan.

I would just like some help in writing the business memo! With this format:

TO:

FROM:

DATE:

SUBJECT

:Body of the memo here. Write clearly using full sentences or bullet points.

Answer 1

a.

Income statement (Partial) for Grayslake for last year
Units sold	198,400
Unit sale price	$5
Sales	$992,000
Less: Variable expenses	$545,600
Contribution margin	$446,400
Less: Fixed costs	$180,000
Net operating income	$266,400

Contribution margin = $446,400

Break-even sales (in units) = Fixed costs / (Selling price per unit – Variable cost per unit)

Or Fixed cost / Contribution margin per unit

Contribution margin per unit = $446,400 / 198,400 units = $2.25 per unit

Therefore, Break-even sales (in units) = $180,000 / $2.25 = 80,000 units

Break-even sales (in dollars) = Fixed cost / Contribution margin ratio

Contribution margin ratio = Contribution margin / Sales * 100

Contribution margin ratio = $446,400 / $992,000 * 100 = 45%

Therefore, Break-even sales(in dollars) = $180,000 / 45% = $400,000

Margin of safety = Current sales – Break-even sales

= $992,000 - $400,000 = $592,000

Margin of Safety ratio = Margin of safety / Sales * 100

= $592,000 / $992,000 * 100 = 60%

Degree of operating leverage = Contribution margin / Operating income

= $446,400 / $266,400 = 1.68

b. Alternative 1: Reduce current price by 8%

Current price = $992,000 / 198,400 = $5 per unit

New price = $5 – (8%*$5) = $4.60

If new sale price is $4.60 per unit, the income details at same level of sales as last year will be:

Alternative 1
Units sold	198,400
Unit sale price	$4.60
Sales	$912,640
Less: Variable expenses	$545,600
Contribution margin	$367,040
Less: Fixed costs	$180,000
Net operating income	$187,040

New Contribution margin = (198,400*$4.60) - $545,000

= $912,640 - $545,000

= $367,040

New break-even point (in units) = $180,000 / New Contribution margin per unit

= $180,000 / $1.85 = 97,297 units

New break-even point (in dollars) = $180,000 / New Contribution margin ratio

New Contribution margin ratio = $367,040 / $912,640 * 100 = 40.2%

So, new break-even point (in dollars) = $180,000 / 40.2% = $447,761.19

New margin of safety = $912,640 - $447,761.19 = $464,878.81

New margin of safety % = $464,878.81 / $912,640 * 100 = 50.94%

New Degree of operating leverage = $367,040 / $187,040 = 1.96

c. Alternative 2: Reduce current variable cost by 0.20 per unit

Last year’s variable expenses per unit = $545,600 / 198,400 = $2.75 per unit

New variable cost per unit = $2.75 - $0.20 = $2.55 per unit

New total variable cost = 198,400 units * $2.55 per unit = $505,920

So, new contribution margin and income as per Alternative 2 will be as follows:

Alternative 2
Units sold	198,400
Unit sale price	$5
Sales	$992,000
Less: Variable expenses	$505,920
Contribution margin	$486,080
Less: Fixed costs	$180,000
Net operating income	$306,080

New Contribution margin = $486,080

New break-even point (in units) = $180,000 / $2.45 = 73,469 units

New break-even point (in dollars) = $180,000 / New contribution margin ratio

New contribution margin ratio = $486,080 / $992,000 * 100 = 49%

So, New break-even point (in dollars) = $180,000 / 49% = $367,346.94

New margin of sales = $992,000 - $367,346.94 = $624,653.06

New margin of safety ratio = $624,653.06 / $992,000 * 100 = 62.97%

New Degree of operating leverage = $486,080 / $306,080 = 1.59

d. Alternative 3: Reduce current price by 8% and variable cost per unit by 0.20

So, new current price per unit will be $5 – ($5*0.08) = $4.60

And new variable cost per unit will be $2.75 - $0.20 = $2.55

Based on this, new contribution margin and income based on same sales units as last year will be:

Alternative 3
Units sold	198,400
Unit sale price	$4.60
Sales	$912,640
Less: Variable expenses	$505,920
Contribution margin	$406,720
Less: Fixed costs	$180,000
Net operating income	$226,720

So, new contribution margin = $406,720

New break-even point (in units) = $180,000 / $2.05 = 87,805 units

New break-even point (in dollars) = $180,000 / New contribution margin ratio

New contribution margin ratio = $406,720 / $912,640 * 100 = 44.5%

So, New break-even point (in dollars) = $180,000 / 44.5% = $404,494.38

New margin of sales = $912,000 - $404,494.38 = $508,145.62

New margin of safety ratio = $508,145.62 / $912,000 * 100 = 55.67%

New Degree of operating leverage = $406,720 / $226,720 = 1.79

e. Alternative 4: Reduce variable cost by 0.65 per unit and increase fixed cost by $50,000

So, the new variable cost per unit will be $2.75 - $0.65 = $2.10

And new fixed cost will be $180,000 + $50,000 = $230,000

The new contribution margin and income will be:

Alternative 4
Units sold	198,400
Unit sale price	$5
Sales	$992,000
Less: Variable expenses	$416,640
Contribution margin	$575,360
Less: Fixed costs	$230,000
Net operating income	$345,360

So, new contribution margin = $575,360

New break-even point (in units) = $230,000 / $2.90 = 79,310 units

New break-even point (in dollars) = $230,000 / New contribution margin ratio

New contribution margin ratio = $575,360 / $992,000 * 100 =58%

So, New break-even point (in dollars) = $230,000 / 58% = $396,551.72

New margin of sales = $992,000 - $396,551.72 = $595,448.28

New margin of safety ratio = $595,448.28 / $992,000 * 100 = 60%

New Degree of operating leverage = $575,360 / $345,360 = 1.67

f. Alternative 5: Fixed expenses increase by $20,000 ( $40,000 * 2 salespersons - $60,000) and variable cost increases by $0.25 per unit

The contribution and income under this scenario will look like :

Alternative 5
Units sold	198,400
Unit sale price	$5
Sales	$992,000
Less: Variable expenses	$595,200
Contribution margin	$396,800
Less: Fixed costs	$200,000
Net operating income	$196,800

So, new contribution margin = $396,800

New break-even point (in units) = $200,000 / $2 = 100,000 units

New break-even point (in dollars) = $200,000 / New contribution margin ratio

New contribution margin ratio = $396,800 / $992,000 * 100 = 40%

So, New break-even point (in dollars) = $200,000 / 40% = $500,000

New margin of sales = $992,000 - $500,000 = $492,000

New margin of safety ratio = $492,000 / $992,000 * 100 = 50%

New Degree of operating leverage = $396,800 / $196,800 = 2.01

Compiling all of the above alternatives we get,

	Base case	Alt 1	Alt 2	Alt 3	Alt 4	Alt 5
CM	446400	367040	486080	406720	575360	396800
BEP UNITS	80000	97297	73469	87805	79310	100000
BEP SALES	400000	447761	367346	404494.4	396551	500000
MOS	592000	464878	624653	508145	595448	492000
MOS %	60%	50.94%	62.97%	55.67%	60%	50%
DOL	1.68	1.96	1.59	1.79	1.67	2.01

If the Company is considering increasing sales in the next two to three years, the maximum advantage will be obtained in Alternative 5 as it has the highest Degree of Operating leverage, which is the ratio of how operating profits change will change in sales levels.