Question

You have recently been employed by a consulting firm as a management accounting specialist. The firm specialises in the provision of information to companies that have discrete, short term problems. Your first assignment is to a company called Malvern who specialises in construction equipment and is having trouble identifying the reasons for volatility in the profitability of its main product: The Hammer. The managers of Malvern are aware that there are a number of factors which are potentially causing them problems. For instance, The Hammer is a product which has a large number of competing products in a market. The market also fluctuates with the fortunes of the construction industry. As a result both the demand and achievable market price of the Hammer are likely to change rapidly and without notice. Further, the materials required to make The Hammer tend to have a volatile price, thus affecting the variable cost of production. Finally, the managers observe that there are a large number of machines used on the production line which they replace on a rolling program, which has helped to smooth their capital investment flows. Recently, however, they have found that the market for these machines has become unstable leading to unpredictability in the prices that they pay for them. The managers feel that they can tackle any of the problems mentioned, by seeking more secure sources of supply for materials or replacement plant; or, by working to establish a stronger brand image that may help to stabilise demand and/or prices. By doing this they feel that they can stabilise the profitability of Malvern. Of course the managers have limited resources and what they want to know is where they should focus their effort first. To ascertain this they want you to establish which of the factors mentioned is the one to which their profit is most sensitive. The following details from the product budget for the year to December 2008 have been provided to you by the managers: 1. Budgeted sales of The Hammer are 230,000 units 2. The expected selling price is £7.75 per unit 3. Variable costs are estimated at £1.95 per unit 4. Fixed costs are estimated at £587, 000

Required: a) Using each of the four elements (units sold, selling price per unit, variable costs, and fixed costs), prepare a sensitivity analysis schedule assuming that each of the elements change by a factor of +15%, +10%, + 5%, -5%, -10%, and -15% respectively, while the remaining elements remain constant.

b) Using the results from part a) prepare a report for the managers of Malvern highlighting those factors that most affect the profitability of their product. Your report should include any provisos or other qualifications that you feel are necessary to help the managers understand the strengths and limitations of your analysis.

Answer 1

1. Statement showing sensitivitiy analysis schedule:

Sensitivity analysis schedule of change in Selling Price

Particulars	0%	+15%	+10%	+5%	-5%	-10%	-15%
Selling Price per unit	7.75	8.9125	8.525	8.1375	7.3625	6.975	6.5875
Variabe Cost per unit	-1.95	-1.95	-1.95	-1.95	-1.95	-1.95	-1.95
Contribution per unit	5.80	6.9625	6.575	6.1875	5.4125	5.025	4.6375
Total Number of units	230,000	230,000	230,000	230,000	230,000	230,000	230,000
Total Contribution	1,334,000	1,601,375	1,512,250	1.423.125	1,244,875	1,155,750	1,066,625
Fixed Cost	-587,000	-587,000	-587,000	-587,000	-587,000	-587,000	-587,000
Net Income	747,000	1,014,375	925,250	836,125	657,875	568,750	479,625
% Change in Net Income	-	35.79%	23.86%	11.93%	-11.93%	23.86%	35.79%

Sensitivity analysis schedule of change in Variable cost

Particulars	0%	+15%	+10%	+5%	-5%	-10%	-15%
Selling Price per unit	7.75	7.75	7.75	7.75	7.75	7.75	7.75
Variabe Cost per unit	-1.95	-2.2425	-2.145	-2.0475	-1.8525	-1.755	-1.6575
Contribution per unit	5.80	5.5075	5.605	5.7025	5.8975	5.995	6.0925
Total Number of units	230,000	230,000	230,000	230,000	230,000	230,000	230,000
Total Contribution	1,334,000	1,266,725	1,289,150	1.311,575	1,356,425	1,378,850	1,401,275
Fixed Cost	-587,000	-587,000	-587,000	-587,000	-587,000	-587,000	-587,000
Net Income	747,000	679,725	702,150	724,575	769,425	791,850	814,275
% Change in Net Income	-	-9%	-6%	-3%	3%	6%	9%

Sensitivity analysis schedule of change in number of units

Particulars	0%	+15%	+10%	+5%	-5%	-10%	-15%
Selling Price per unit	7.75	7.75	7.75	7.75	7.75	7.75	7.75
Variabe Cost per unit	-1.95	-1.95	-1.95	-1.95	-1.95	-1.95	-1.95
Contribution per unit	5.80	5.80	5.80	5.80	5.80	5.80	5.80
Total Number of units	230,000	264,500	253,000	241,500	218,500	207,000	195,500
Total Contribution	1,334,000	1,534,100	1,467,980	1.400,700	1,267,300	1,200,600	1,133,900
Fixed Cost	-587,000	-587,000	-587,000	-587,000	-587,000	-587,000	-587,000
Net Income	747,000	947,100	880,980	813,700	680,300	613,600	546,900
% Change in Net Income	-	26.79%	17.94%	8.93%	-8.93%	-17.94%	-26.79%

Sensitivity analysis schedule of change in fixed cost

Particulars	0%	+15%	+10%	+5%	-5%	-10%	-15%
Selling Price per unit	7.75	7.75	7.75	7.75	7.75	7.75	7.75
Variabe Cost per unit	-1.95	-1.95	-1.95	-1.95	-1.95	-1.95	-1.95
Contribution per unit	5.80	5.80	5.80	5.80	5.80	5.80	5.80
Total Number of units	230,000	230,000	230,000	230,000	230,000	230,000	230,000
Total Contribution	1,334,000	1,334,000	1,334,000	1,334,000	1,334,000	1,334,000	1,334,000
Fixed Cost	-587,000	-675,050	-645,700	-616,350	-557,650	-528,300	-498,950
Net Income	747,000	658,950	688,300	717,650	776,350	805,700	835,050
% Change in Net Income	-	-11.79%	-7.86%	-3.93%	3.93%	7.86%	11.79%

2. From the above table we can infer the following details and present the following observations that are affecting the profitablity:

• Sensitivity to change in sales is the highest as a mere 5% change in sales results in 11.93% change in net income and change upto 15% in sales value results in 35.79% change in net income, thus selling price has the highest sensitivity
• Sensitivity to change in variable cost is pretty linear and very low as the amount in totality is pretty low, at 5% change in variable cost there is 3% sensitivity to net income, while at 15% change in variable cost there is 9% sensitivity to net income, thus every 5% change in variable cost results is 3% sensitivity.
• Sensitivity to change in Number of units is second most sensitive factor after change in selling price. At 5% change there is 8.93% sensitivity to net income, while at 15% change in number of units results in 26.79% sensitivity to net income.
• Sensitivity to change in fixed costs is non-linear and at 5% change in fixed costs there is sensitivity of 3.93% to net income, while at 15% change in fixed costs there is sensitivity of 11.79% thus we can infer that with increase in change in fixed costs, the sensitivity will increase and vice versa.