Question

Vernon Company is considering the addition of a new product to its cosmetics line. The company has three distinctly different options: a skin cream, a bath oil, or a hair coloring gel. Relevant information and budgeted annual income statements for each of the products follow.

	Relevant Information
	Skin Cream				Bath Oil				Color Gel
Budgeted sales in units (a)		136,000				216,000				96,000
Expected sales price (b)	$	9			$	7			$	15
Variable costs per unit (c)	$	2			$	4			$	10
Income statements
Sales revenue (a × b)	$	1,224,000			$	1,512,000			$	1,440,000
Variable costs (a × c)		(272,000	)			(864,000	)			(960,000	)
Contribution margin		952,000				648,000				480,000
Fixed costs		(777,000	)			(555,000	)			(160,000	)
Net income	$	175,000			$	93,000			$	320,000

  
Required:

1. Determine the margin of safety as a percentage for each product.

2. Prepare revised income statements for each product, assuming a 20 percent increase in the budgeted sales volume.

3. For each product, determine the percentage change in net income that results from the 20 percent increase in sales.

4. Assuming that management is pessimistic and risk-averse, which product should the company add to its cosmetics line?

5. Assuming that management is optimistic and risk aggressive, which product should the company add to its cosmetics line?

Answer 1

a) Calculation of Margin of safety percentage is shown as follows:-   (Amounts in $)   

	Skin Cream	Bath Oil	Color Gel
1) Fixed Costs	777,000	555,000	160,000
2) Expected Sales Price per unit	9	7	15
3) Variable Cost per unit	2	4	10
4) Contribution Per unit (2-3)	7	3	5
5) Break Even Point (in units) (1/4)	111,000	185,000	32,000
6) Current Budgeted Sales (in units)	136,000	216,000	96,000
7) Margin of Safety (in units)	25,000	31,000	64,000
8) Margin of safety Percentage [(7/6)*100]	18.38%	14.35%	66.67%

b) Revised Income statement after 20% increase in budgeted volume is shown as follows:-   

	Skin Cream			Bath Oil			Color Gel
Budgeted sales in units (a)		136,000			216,000			96,000
Expected sales after 20% increase (b = a*1.2)		163,200			259,200			115,200
Expected sales price (c)	$	9		$	7		$	15
Variable costs per unit (d)	$	2		$	4		$	10
Income statements
Sales revenue (b × c)	$	1,468,800		$	1,814,400		$	1,728,000
Variable costs (b × d)		(326,400)			(1,036,800)			(1,152,000)
Contribution margin		1,142,400			777,600			576,000
Fixed costs		(777,000)			(555,000)			(160,000)
Net income	$	365,400		$	222,600		$	416,000

c) Calculation of percentage change in income after 20% increase in sales volume   

	Skin Cream	Bath Oil	Color gel
1) Net Income before change	$175,000	$93,000	$320,000
2) Net income after change	$365,400	$222,600	$416,000
3) Percentage change [(2-1)*100]	108.80%	139.35%	30%

d) Firstly we need to rank all the three products on the basis of Margin of safety %, Net income after increase in sales volume and % increase in net income which is shown as follows:-

	Skin Cream	Bath Oil	Color Gel
i) Margin of Safety %	18.38%	14.35%	66.67%
Ranking	2	3	1
ii) Net income after increase in sales volume	$365,400	$222,600	$416,000
Ranking	2	1	3
iii) Percentage Increase in net income	108.80%	139.35%	30%
Ranking	2	1	3

Based on the above rankings, skin cream is the only product which is out of ranking 3. Therefore the company should add skin cream to its cosmetics line. (Assuming management is pessimistic and risk-averse).

e) Based on the above rankings, bath oil is the only product which is ranked at first position twice. Therefore the company should add bath oil to its cosmetics line. (Assuming management is optimistic and risk-aggressive).