Question

Management from Global Shippers Inc, an international shipping business, is in the process of assessing the choice between two different cost structures for the business. Option A has relatively higher variable costs per unit shipped but lower annual fixed costs, while Option B has the opposite—relatively lower variable costs in its cost structure but higher fixed costs. Assume that delivery selling prices per unit are constant. The table below contains critical information in making the decision:

Cost Information	Option A	Option B
Delivery price (revenue) per shipment	$100	$100
Variable cost per shipment delivered	$85	$60
Contribution Margin per unit	$15	$40
Fixed costs (annual)	$1,200,000	$4,500,000

Management wants you to write a professional report, answering the following questions:

Questions

1) What is the break-even point, in terms of volume (i.e., number of shipments per year), for Option A? Option B?

(2) How many shipments would have to be made under Option A to produce operating income of $30,000 for an annual period?

(3) How many shipments per year would have to be made under Option A to produce an operating margin equal to 9% of sales revenue?

(4) How many shipments are required under Option B to produce net income of $180,000 per year, given a corporate tax rate of 40%?

(5) Assume that for the coming year total fixed costs are expected to increase by 15% for each of the two options. What is the new break-even point, in terms of number of shipments, for each option? By what percentage did the break-even point change for each case? How do these figures compare to the percentage increase in budgeted fixed costs?

(6) Assume an average income-tax rate of 20%. What volume (number of shipments) would be needed to generate net income of 5% of revenue for each option?

(7) Which option do you think is the more profitable one for this business? Explain.

(8) Which option do you consider to be more risky to the business? Explain (calculate degree of operating leverage to help answer this question).

Answer 1

1. The computation of break-even point, in terms of volume (i.e., number of shipments per year), for Option A and Option B is shown below:-

	Product A	Product B
Delivery price	$100	$100
Variable cost	$85	$60
Contribution (a)	$15	$40
Fixed cost (b)	$1,200,000	$4,500,000
Break-even sales (b / a)	$80,000	$112,500

2. The computation of shipments would have to be made under Option A is shown below:-

Fixed cost	$1,200,000
Operating income required	$30,000
Total contribution required	$1,230,000
Contribution per unit	$15
Number of shipment needed ($1,230,000 / $15)	$82,000

3. The computation of shipments per year is shown below:-

Break-even sales volume	$80,000
Break-even sales ($80,000 * $100)	$8,000,000
Operating Margin needed ($8,000,000 * 9%)	$720,000
Fixed cost	$1,200,000
Required total contribution	$1,920,000
Contribution per unit	15
Needed number of shipment ($1,920,000 / $15)	$128,000

4. For computation of shipments are required under Option B first we need to find out the total contribution required whcih is shown below:-

Total contribution required = Income before tax + Fixed cost

= ($180,000 / 60%) + $4,500,000

= $300,000 + $4,500,000

= $4,800,000

Numver of shipment required = Total contribution required / Contribution per unit

= $4,800,000 / $40

= $120,000