Question

Zachary Company is considering the addition of a new product to its cosmetics line. The company has three distinctly different options: a skin cream, a bath oil, or a hair coloring gel. Relevant information and budgeted annual income statements for each of the products follow.

	Relevant Information
	Skin Cream				Bath Oil				Color Gel
Budgeted sales in units (a)		140,000				220,000				100,000
Expected sales price (b)	$	7			$	7			$	15
Variable costs per unit (c)	$	2			$	4			$	11
Income statements
Sales revenue (a × b)	$	980,000			$	1,540,000			$	1,500,000
Variable costs (a × c)		(280,000	)			(880,000	)			(1,100,000	)
Contribution margin		700,000				660,000				400,000
Fixed costs		(585,000	)			(585,000	)			(136,000	)
Net income	$	115,000			$	75,000			$	264,000

  
Required:

Determine the margin of safety as a percentage for each product.

Prepare revised income statements for each product, assuming a 20 percent increase in the budgeted sales volume.

For each product, determine the percentage change in net income that results from the 20 percent increase in sales.

Which product has the highest operating leverage?

Assuming that management is pessimistic and risk averse, which product should the company add to its cosmetics line?

Assuming that management is optimistic and risk aggressive, which product should the company add to its cosmetics line?

Answer 1

1. Margin of safety %:

		Skin Cream	Bath Oil	Color Gel
a	Expected sales price	7	7	15
b	Variable cost per unit	2	4	11
c	Difference (a - b)	5	3	4
d	Fixed costs	585000	585000	136000
e	Margin of safety Units (d / c)	117000	195000	34000
f	Budgeted sales in units	1,40,000	2,20,000	1,00,000
g	Budgeted sales (f * a)	9,80,000	15,40,000	15,00,000
h	Margin of safety revenue (e * a)	8,19,000	13,65,000	5,10,000
i	Difference (g - h)	1,61,000	1,75,000	9,90,000
j	Margin of safety % (i / g *100)	16.43%	11.36%	66.00%

2. Revised income statement after 20% increase in sales:

		Skin Cream	Bath Oil	Color Gel
a	Budgeted sales in units	1,40,000	2,20,000	1,00,000
b	New Budgeted Sales (a * 1.20)	168000	264000	120000
c	Expected sales price	7	7	15
d	Variable cost per unit	2	4	11
	Income Statements
e	Sales Revenue (b * c)	1176000	1848000	1800000
f	Variable Costs (b * d)	336000	1056000	1320000
g	Contribution margin (e - f)	840000	792000	480000
h	Fixed costs	585000	585000	136000
i	Net Income (g - h)	255000	207000	344000

3. Percentage change in net income:

	Skin Cream	Bath Oil	Color Gel
Net Income	115000	75000	264000
Net Income after 20% inc in sales	255000	207000	344000
Percentage change in net income	221.74%	276.00%	130.30%

4. Bath Oil has the highest operating leverage as shown below:

		Skin Cream	Bath Oil	Color Gel
a	Contribution margin	700000	660000	400000
b	Fixed Costs	585000	585000	136000
c	Net Income (a - b)	115000	75000	264000
d	Operating leverage ( a / c)	6.09	8.80	1.52

5. Assuming that the management is pessimistic and risk averse, the company will add Color Gel to its cosmetics line as it has the highest margin of safety percentage (66%) or lowest margin of safety units (34000) due to very low fixed costs compared to others.

6. Assuming the management is optimistic and risk aggressive, the company will add will add Bath Oil to its cosmetics line as it has the highest operating leverage (8.8) and also the percentage increase in net income due to increase in sales (276%) is highest.