Question

After graduating with an accounting degree from Major Metropolitan University and five years in public accounting, you decided to explore other professional options. You recently accepted an offer from your former classmate to join his accounting firm and are excited about your future prospects with the firm.

Gloria Walstrom has been a long-time client of the consulting firm. Her work experience has been largely confined to the transportation business, in which she has broad administrative and marketing experience, but not much accounting experience. Recent events have motivated Gloria to consider starting a new package-delivery-service venture, the proposed name of which is ‘Pack-It-Up’. She is acutely aware of the fact that with electronic commerce, such as Amazon and eBay, there is an increase in business demands for package delivery. She wonders, therefore, whether the timing might be right for a smaller, focused competitor along the lines of the business envisioned by Pack-It-Up. Such a venture would initially focus on intra-city deliveries in a major metropolitan center.

Because of her lack of financial experience and her long-time professional association with your classmate, Gloria recently contacted your firm with a request that the firm help her perform some financial planning. You will work with Gloria to create a profit-planning model (otherwise referred to as cost-volume-profit, or CVP, analysis) that responds to numerous questions regarding the profitability and financial risk associated with Pack-It-Up.

You will need to consider the single-product case, with two decision options related to choice of cost structure. Under cost structure alternative 1, Pack-It-Up would essentially contract with delivery personnel who would be paid on a commission basis. Delivery personnel in this situation would use their own vehicles (bicycles, motor bikes, etc.). This would result in a reduced capital investment on the part of Pack-It-Up with lower fixed costs. Under cost structure alternative 2, Pack-It-Up would provide its own fleet of delivery trucks (with associated depreciation, insurance charges, scheduled/fixed maintenance costs, etc.) and would pay its delivery personnel a fixed salary per year. Thus, it would incur relatively higher fixed costs.

Fixed costs under both decision alternatives would also include some administrative salaries and office-related expenses as well as advertising/promotion costs determined on a yearly contract basis. Accounting and tax- consulting costs are fixed on an annual basis under both alternatives.

To facilitate the profit-planning process, Gloria has obtained from trusted colleagues in a related business estimated costs associated with each of the two alternative cost structures (see table below). These estimated data are to be used as the basis of the consulting report you prepare for Gloria in response to the questions, she has raised in conjunction with the proposed business venture.

Decision inputs (data)

Data:
	Cost structure alternative 1	Cost structure alternative 2
Delivery price per package delivered	$70	$70
Variable cost per package delivered	$52	$35
Fixed costs (per year)	$650,000	$2,799,500

Case A Requirements

Provide a written report to address the following questions. This report will be presented to the client, so it should be written professionally. Your report should show your calculations.

1. One issue of interest to your client is the volume of business (on an annual basis) needed for her to ‘break even’. Calculate the break-even point, in terms of number of deliveries (i.e. units per year) and dollars for cost structure alternative 1 and cost structure alternative 2.
2. Gloria estimates that sales volume will be 60,000 units for alternative 1 and 120,000 units for alternative 2. What is the margin of safety for cost structure alternative 1, in both units and in dollars at that sales volume? What is the margin of safety ratio for both alternatives? Explain to Gloria what is meant by margin of safety and what information it provides.

Answer 1

Calculation of break even point
	Alt 1	Alt 2
Selling price per unit	$                  70	$                      70
Variable cost per unit	$                (52)	$                    (35)
Contribution per unit	$                  18	$                      35
Fixed costs	$        650,000	$        2,799,500
BEP=Fixed cost/Contribution per unit
In number of deliveries	36,111	79,986
x Selling price per unit	70	70
In $	2,527,770	5,599,020
Calculation of margin of safety
	Alt 1	Alt 2
In units
Expected sales	60,000	120,000
Less: Break even sales	(36,111)	(79,986)
Margin of Safety	23,889	40,014
In $
Expected sales	4200000	8400000
Less: Break even sales	(2,527,770)	(5,599,020)
Margin of Safety	1,672,230	2,800,980
Margin of safety ratio =(Margin of Safety/Expected Sales)*100	39.82%	33.35%

Margin of safety measures the units/sales value over and above the number of units/sales value at which the company's fixed cost exactly equals the contribution earned by the company (i.e. the break even point). It helps in evaluating the level of comfort at which the company's sales contribute to the overall profitability, as any units sold over and above the break even point results in profits for the company. A high margin of safety indicates sound functioning of business operations.

In case of any questions on the above workings, please share the same in the comments section.

All the best!