Question

Falkirk Ltd. produces a single product, the Thingme. Last year it sold 100,000 units with the following results: Sales $2,500,000 Variable Costs $1,000,000 Fixed costs $ 400,000 Operating income before taxes. $ 1,100,000 In an effort to improve the quality of its product, Falkirk is considering replacing one of its component parts, which costs $2 per unit, with an improved component which will cost $3 per unit. It will also have to purchase a new piece of equipment in order to change their production process. It will cost $120,000 and will have an expected useful life of 5 years. At the end of the 5 years, it will be obsolete and will be sold for $20,000. The company depreciates all of its assets using the straight-line method. The corporate tax rate is 30%. REQUIRED: SHOW ALL CALCULATIONS. ALL PARTS ARE INDEPENDENT. 1. Senior management expects that the new component will improve the Thingme’s quality. Would a 10% increase in number of units sold increase the overall profitability of Fakirk? 2. How many units would Falkirk have to sell, after it makes the changes noted above, to earn an after tax income of $575,000? 3. Calculate the margin of safety, in units, if the changes are made but there is no increase in number of units sold. Has the margin of safety improved or deteriorated from last year’s actual results? What does the margin of safety tell us? 4. If Falkirk does not change the selling price but makes the changes noted above, how many units would Falkirk have to sell to earn the same income after tax as last year?

Answer 1

	Last year	Last year	Increase	Current year
units	100000	1	10000	110000
Sales	2500000	25		25
Variable costs	1000000	10	1	11
Fixed costs	400000	400000	20000	420000
operating income	1100000
tax 30%	330000
Net profit	770000

	Last yr	Current yr
Sales price	25	25
variable cost	10	11
Contribution	15	14

1.

Revised income statement
units	110000
Sales	2750000
Variable costs	1210000
Fixed costs	420000
operating income	1120000
tax 30%	336000
Net profit	784000

Yes, 10% increase in units sold will increase profitability

2

After tax income of 575000
So before tax income	=575000/0.7
	821428
Contribution required	=fixed costs+target profit
	=420000+821428
	1241428
Per unit contribution	=25-11
	14
Units required	(fixed costs+targeted profit)/contribution per unit
	=1241428/14
	88673.43
	88674
units	88674
Sales	2216850
Variable costs	975414
Fixed costs	420000
operating income	821436
tax 30%	246430.8
Net profit	575005.2

3.

Break-even point revised	=420000/14
	30000
Margin of safety old	=100000-30000
	70000
Last year
Break even	=400000/15
	26666.66667
Margin of safety	=100000-26667
	73333
Margin of safety has deteriorated

Margin of safety is the gap between estimated sales output and level by which a company's sales or contribution could decrease and fixed costs could increase before the company will become unprofitable

4

Target profit after tax	770000
Tax 30%
Before tax	=770000/0.7
	1100000
Units to earn target profit	=(fixed cost+target profit)/contribution
	=(420000+1100000)/14
	108571.4286
	108571 units

Increase in fixed costs	=(120000-20000)/5
	20000