Question

ABC Hotel Limited (“ABCHL”) operates a small store selling spa oil. ABCHL sells each unit for $80. Variable costs per unit equal $40. Total fixed costs equal $460,000. ABCHL is currently selling 12,000 units per period. The management would like to earn net income of $80,000.

ABCHL considers whether a promotion campaign to be carried out in next year. The cost of the promotion campaign is $100,000. The expected increase in unit of sales is 20% and 30% if the selling price is $80 and $72 respectively.

(a) Compute:
(i) Contribution margin per unit in dollars.
(ii) Contribution margin percentage.
(iii) Break-even point in dollars.
(iv) Break-even in units.
(v) Sales units necessary to attain desired income of $80,000. (vi) Margin of safety ratio for current operations.

(b) Should ABCHL carry out the promotion campaign in next year. Justify your answer by showing all relevant calculations.

Answer 1

(i) Contribution margin per unit in dollars = Sale price per unit - Variable cost per unit

Therefore, Contribution margin per unit in dollars = $80 - $40 = $40 per unit.

(ii) Contribution margin percentage = Contribution per unit / Sale price per unit * 100

Therefore, Contribution margin percentage = $40/$80 * 100 = 50%

(iii) Break Even Point in dollars = Fixed Cost / Contribution margin percentage

Therefore, Break-Even Point in dollars = $460,000 / 50% = $920,000

(iv) Break-even in units = Fixed Cost / Contribution margin per unit

Therefore, Break-even in units = $460,000 / $40 = 11,500 units

(v) Sales units necessary to attain desired income of $80,000

Desired Contribution = Fixed Cost + Desired income

Desired Contribution = $460,000 + $80,000 = $540,000

Sales to achieve contribution of $540,000 = Desired Contribution / Contribution margin percentage

Sales to achieve contribution of $540,000 = $540,000 /50% = $1,080,000

Sales in units = $1,080,000 / $80 = $13,500

(vi) Margin of safety ratio = (Current Sales - Break Even point) / Break Even Point *100

Margin of safety ratio = ( (12,000 units * $80) - $920,000) / $920,000 * 100 = 4.34%

b. Computation of Income if promotional campaign is undertaken:

Sales in units = 12,000 + 20% of 12,000 = 14,400 units when selling price = $80

Sales in units = 12,000 + 30% of 12,000 = 15,600 units when selling price = $72

Current Income = Contribution - Fixed Costs = (12,000 * $40) - $460,000 = $20,000

	When Sale increased by 20%	When Sale increased by 30%
Sales
(14,400 units * $80)	$1,152,000
(15,600 units * $72)		$1,123,200
Less: Variable costs	$576,000
(14,400 units * $40)
(15,600 units * $40)		$624,000
Contribution	$576,000	$499,200
Less:
Fixed costs	$560,000	$560,000
($460,000+$100,000)
Net Income	$16,000	-$60,800

As in both the scenario income has decreased from $20,000, therefore promotion campaign should not be undertaken.