Question

Premium Leather has been in the clothing market for the last 10 years and operates in an industry which is very competitive and volatile. The following information on Premium and its product portfolio is available – figures are per annum:

Products	Sales in unit	Selling price per unit	Variable cost (excluding material cost) per unit	Material (leather) per unit
		$	$	Meter
Bags	11,250	400	150	1.00
Belts	12,000	125	50	0.25
Shoes	16,000	150	65	0.50

Leather is a major ingredient and regularly used in the production of all the products above. Leather used in production is bought from a supplier for $60 per meter. Fixed cost per annum is $2,300,000. The CFO of Premium has heard that break-even analysis could be used to assess the risks of the business and helps decision making. You are asked to help him in the analysis.

Required:

a. Calculate the contribution margin per unit for the 3 products.

b. Prepare a contribution margin income statement in thousands dollars.

c. Calculate the contribution margin ratio. Calculate, and briefly explain the significance of the break-even in dollar sales and margin of safety in percentage.

d. What is meant by the term operating leverage? Calculate the degree of operating leverage.

e. What is the percentage increase in sales in order to earn a target profit of $3 million, assume a constant sales mix?

f. Explain how the unavailability of leather and the rise in its price affect the profitability, risk and break-even point of Premium. Answer verbally.

g. In the coming month, the supplier can only supply 1,500 meters of the leather at a cost of $72 per meter to Premium which is not sufficient to meet the potential demand for the month. The potential demand in the coming month for the 3 products are as follows: bags – 800 units, belts – 1,000 units and shoes – 1,200 units. Compute the contribution margin per unit of the constraining resource and determine which products and the amount of the products Premium should produce to maximize its net operating income.

h. A foreign supplier approaches Premium to offer the leather at a substantial premium over the usual price. What is the highest price that Premium should be willing to pay? Explain.

Answer 1

a.	Contribution margin per unit:
					Bags	Belts	Shoes
	Selling price per unit				400	125	150
	Less:
	Material cost per unit				60	15	30
					(1*60)	(0.25*60)	(0.50*60)
	Variable cost (Excl. material cost) per unit				150	50	65
	Contribution margin per unit:				190	60	55
b.		Contribution margin income statement
								$ '000
	Sales revenue		(11250*400)+(12000*125)+(16000*150)					8400
	Less: Variable expenses
	Material cost		(11250*60)+(12000*15)+(16000*30)					1335
	Other variable expenses			(11250*150)+(12000*50)+(16000*65)				3327.5
	Total variable expenses							4662.5
	Contribution margin							3737.5
	Less: Fixed costs							2300
	Net operating income							1437.5
c.	Contribution margin ratio=Contribution margin/Sales revenue=3737.5/8400=0.44494
	Break-even in dollar sales=Fixed costs/Contribution margin ratio=2300/0.44494=$ 5169.236=$ 5169
	Margin of safety in percentage=(Actual sales revenue-Break even dollar sales)/Actual sales revenue=(8400-5169)/8400=0.3846=38.46%
	Break-even sales dollars means the sales revenue at which profit is zero.Beyond this point profit will be positive.
	Margin of safety percentage how much is sales above the break-even level of sales
d.	Operating leverage shows the chane of operating income with change in sales
	Degree of operating leverage=Contribution margin/Operating income=3737.5/1437.5=2.6