Question

Problem 5-22 (Algo) CVP Applications; Contribution Margin Ratio; Break-Even Analysis; Cost Structure [LO5-1, LO5-3, LO5-4, LO5-5, LO5-6]

Due to erratic sales of its sole product—a high-capacity battery for laptop computers—PEM, Inc., has been experiencing financial difficulty for some time. The company’s contribution format income statement for the most recent month is given below:

  

Sales (13,100 units × $20 per unit)	$	262,000
Variable expenses		157,200
Contribution margin		104,800
Fixed expenses		116,800
Net operating loss	$	(12,000	)

Required:

1. Compute the company’s CM ratio and its break-even point in unit sales and dollar sales.

2. The president believes that a $6,600 increase in the monthly advertising budget, combined with an intensified effort by the sales staff, will increase unit sales and the total sales by $90,000 per month. If the president is right, what will be the increase (decrease) in the company’s monthly net operating income?

3. Refer to the original data. The sales manager is convinced that a 10% reduction in the selling price, combined with an increase of $34,000 in the monthly advertising budget, will double unit sales. If the sales manager is right, what will be the revised net operating income (loss)?

4. Refer to the original data. The Marketing Department thinks that a fancy new package for the laptop computer battery would grow sales. The new package would increase packaging costs by $0.70 per unit. Assuming no other changes, how many units would have to be sold each month to attain a target profit of $4,500?

5. Refer to the original data. By automating, the company could reduce variable expenses by $3 per unit. However, fixed expenses would increase by $53,000 each month.

a. Compute the new CM ratio and the new break-even point in unit sales and dollar sales.

b. Assume that the company expects to sell 20,100 units next month. Prepare two contribution format income statements, one assuming that operations are not automated and one assuming that they are. (Show data on a per unit and percentage basis, as well as in total, for each alternative.)

c. Would you recommend that the company automate its operations (Assuming that the company expects to sell 20,100 units)?

Answer 1

Solution:

	Total	Per unit
Sales (13,100 units * $20 per unit)	$262,000	$20
Variable Expenses	$157,200	($157,200/13,100) = $12
Contribution margin	$104,800	$8
Fixed Costs	$116,800
Operating Loss	($12,000)

Requirement 1.

Contribution margin ratio = Contribution margin per unit / Selling price per unit

= $8 / $20 = 40%

Breakeven point (in units) = Fixed costs / Contribution margin per unit

= $116,800 / $8 = 14,600 units

Breakeven point (in dollars) = 14,600 units * $20 = $292,000

Requirement 2.

Incremental contribution margin
$90,000 increased sales * 40% contribution margin ratio	$36,000
Less: Increased advertising costs	$6,600
Increase in monthly net income	$29,400

Requirement 3.

New sales units = 13,100 units * 2 = 26,200 units

New selling price = $20 * 90% = $18 per unit

So,

Sales (26,200 units * $18 per unit)	$471,600
Less: Variable Costs (26,200 units * $12 per unit)	$314,400
Contribution margin	$157,200
Less: Fixed Costs ($116,800 + $34,000)	$150,800
Operating Profit	$6,400

Requirement 4.

New variable cost = $12 + $0.70 = $12.70 per unit

So, Contribution per unit = $20 - $12.70 = $7.30

Required sales to attain target profit = (Target profit + Fixed Costs) / Contribution margin per unit

= ($4,500 + $116,800) / $7.30

= $121,300 / $7.30 = 16,616.44 units rounded to 16,616 units

Requirement 5.

a. New contribution margin ratio will be

	Per unit
Selling price	$20	100%
Less: Variable cost ($12 - $3)	$9	45%
Contribution margin	$11	55%

Breakeven point (in units) = ($116,800 + $53,000) / $11

= $169,800 / $11 = 15,436.36 units rounded to 15,436 units

Breakeven point (in dollars) = 15,436 units * $20 = $308,720

b.

	With automation			Without automation
Units	20,100			20,100
	Per unit	Percentage	Total	Per unit	Percentage	Total
Sales	$20	100%	$402,000	$20	100%	$402,000
Less: Variable costs	$9	45%	$180,900	$12	60%	$241,200
Contribution margin	$11	55%	$221,100	$8	40%	$160,800
Less: Fixed Costs			$116,800 + $53,000 = $169,800			$116,800
Operating Profit			$51,300			$44,000

c. Yes I would recommend automation due to increased profits.

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