Question

Critical Thinking Example

         Island Novelties, Inc., of Palau makes two products, Hawaiian Fantasy and Tahitian Joy. Present revenue, cost, and sales data on the two products follow:

                                                          Hawaiian Fantasy      Tahitian Joy

   Selling price per unit                                   $15                       $100

   Variable expenses per unit                               9                           20

   Number of units sold annually              20,000                      5,000

Fixed expenses total $475,800 per year. The Republic of Palau uses the U.S. dollar as its currency.

REQUIRED

1. Assuming the sales mix given above, do the following:

1. Prepare a contribution income statement showing both dollar and percent columns for each product and for the company as a whole.
2. Compute the break-even point in dollars for the company as a whole and the margin of safety in both dollars and percent.

2. Another product, Samoan Delight, has just come onto the market. Assume that the company could sell 10,000 units at $45 each. The variable expenses would be $36 each. The company's fixed expenses would not change.

1. Prepare another contribution income statement, including sales of the Samoan Delight (sales of the other two products would not change). Carry percentage computations to one decimal place.
2. Compute the company’s new break-even point in dollars and the new margin of safety in both dollars and percent.

3. The president of the company examines your figures and says, “There’s something strange here. Our fixed costs haven’t changed and you show greater total contribution margin if we add the new product, but you also show our break-even point going up. With greater contribution margin, the break-even point should go down, not up. You’ve made a mistake somewhere.” Explain to the president what has happened.

Answer 1

Contribution format Income Statement
	Hawaiian Fantasy		Tahatian Joy		Total
	Amount	%	Amount	%	Amount	%
Sales	300000	100.00%	500000	100.00%	800000	100.00%
Variable Expenses	180000	60.00%	100000	20.00%	280000	35.00%
Contribution Margin	120000	40.00%	400000	80.00%	520000	65.00%
Fixed Expenses					475800	59.48%
Net Operating Income					44200	5.53%
Break even point in dollar sales = Fixed costs/Contribution margin ratio
732,000.00
i.e.	$732,000
Margin of safety = Sales - Break even Sales	68,000
in % = Margin of Safety in Dollars/Sales	8.50%
Contribution format Income Statement
	Hawaiian Fantasy		Tahatian Joy		Samaon Delight		Total
	Amount	%	Amount	%	Amount	%	Amount	%
Sales	300000	100.00%	500000	100.00%	450000	100.00%	1250000	100.00%
Variable Expenses	180000	60.00%	100000	20.00%	360000	80.00%	640000	51.20%
Contribution Margin	120000	40.00%	400000	80.00%	90000	20.00%	610000	48.80%
Fixed Expenses							475800	38.06%
Net Operating Income							134200	10.74%
Break even point	975,000.00
Margin of safety	275,000.00
in %	22.00%
The break even point has gone up as Weighted average Contribution Margin % has gone down due to addition to Samaon Delight