Question

QUESTION 1

Study the information given below and answer each of the following questions independently:

•           Calculate the margin of safety (as a percentage).

•           Calculate the number of units that must be sold if the company desires an operating profit of $1 350 000.

•           Suppose the company wants to spend $120 000 more on advertising and reduce the selling price by $4 per unit, with the expectation that the sales volume will increase by 20%. Is this a good idea? Motivate your answer.

INFORMATION

Aqua Ltd manufactures a product that sells for $54 each. Production and sales are presently 100 000 units per year. Variable manufacturing costs are $27.30 per unit, of which $5.00 per unit are for overheads. Salespersons earn a commission of 5% of sales. Fixed costs amount to $1 360 000 for manufacturing overheads and $590 000 for selling and administrative activities.

Answer 1

1. Margin of safety= 8.33 %( See working note 1)

2. Number of units=137500( See working note 2)

3. NO It is NOT A GOOD IDEA( as per working note 3) It is not worthwhile as inspite of the increase in sales volume by 20% there is NO INCREASE IN the Total contribution as the price per unit has been decreased by $ 5 (but no change in the variable cost per unit) but an additional advertising cost of $120000 had been incurred and the resultant effect is that the operating profit has reduced by $ 120000 and accordingly the plan should not be implemented.

Working Note:

1. Statement of Profitability

Particulars	Cost ($)	Cost ($ )
Selling Price per unit		$54
Less: Variable Costs
Variable ManufacturingCost(excl overheads)	$ 22.30
Variable Manufacturing Overhead	$5
Variable Selling Overheads	$ 2.70	$ 30
Contribution per unit		$ 24
Number of units		1,00,000
Total Contribution		$ 24,00,000
Less: Fixed Costs
Manufacturing Overheads	$ 13,60,000
Selling & Administrative Overheads	$ 5,90,000	$ 19,50,000
Total Operating Profits		$4,50,000

Break Even Sales=$ 30,00,000+$ 19,50,000=$ 49,50,000

Actual Sales( $ 54* 1,00,000 units)=$54,00,000

Margin Of Safety= Actual Sales- Break Even Sales=$ 4,50,000

Margin of Safety(as a percentage) =$ 450000*100/$ 5400000=8.33 %

2. Desired Operating Profit=$ 13,50,000

Fixed Cost = $ 19,50,000

Total Desired Contribution =$ 33,00,000

Contribution per unit= $ 24

Number of units required to be sold= $ 33,00,000/$ 24=1,37,500

3. If the company desires to spend $ 120000 on Advertising , Reduce the selling price per unit by $4, Sales volume is expected to increase by 20 %

Statement of Profitability

Particulars	Cost ($)	Cost ($ )
Selling Price per unit		$50
Less: Variable Costs
Variable ManufacturingCost(excl overheads)	$ 22.30
Variable Manufacturing Overhead	$5
Variable Selling Overheads	$ 2.70	$ 30
Contribution per unit		$ 20
Number of units		1,20,000
Total Contribution		$ 24,00,000
Less: Fixed Costs
Manufacturing Overheads	$ 13,60,000
Selling & Administrative Overheads(including additional Advertising Cost of $ 120000)	$ 7,10,000	$ 20,70,000
Total Operating Profits		$3,30,000