Question

Due to erratic sales of its sole product—a high-capacity battery for laptop computers—PEM, Inc., has been experiencing financial difficulty for some time. The company’s contribution format income statement for the most recent month is given below:

  

Sales (12,700 units × $20 per unit)	$	254,000
Variable expenses		127,000
Contribution margin		127,000
Fixed expenses		142,000
Net operating loss	$	(15,000	)

Required:

1. Compute the company’s CM ratio and its break-even point in unit sales and dollar sales.

2. The president believes that a $6,200 increase in the monthly advertising budget, combined with an intensified effort by the sales staff, will result in an $90,000 increase in monthly sales. If the president is right, what will be the increase (decrease) in the company’s monthly net operating income?

3. Refer to the original data. The sales manager is convinced that a 10% reduction in the selling price, combined with an increase of $31,000 in the monthly advertising budget, will double unit sales. If the sales manager is right, what will be the revised net operating income (loss)?

4. Refer to the original data. The Marketing Department thinks that a fancy new package for the laptop computer battery would grow sales. The new package would increase packaging costs by $0.80 per unit. Assuming no other changes, how many units would have to be sold each month to attain a target profit of $4,800?

5. Refer to the original data. By automating, the company could reduce variable expenses by $3 per unit. However, fixed expenses would increase by $60,000 each month.

a. Compute the new CM ratio and the new break-even point in unit sales and dollar sales.

b. Assume that the company expects to sell 20,200 units next month. Prepare two contribution format income statements, one assuming that operations are not automated and one assuming that they are. (Show data on a per unit and percentage basis, as well as in total, for each alternative.)

c. Would you recommend that the company automate its operations (Assuming that the company expects to sell 20,200)?

Answer 1

Solution

PEM Inc

1. Computation of CM ratio and break-even point in unit sales and dollar sales:

CM ratio = (contribution margin/sales) x100

Contribution margin = $127,000

Sales = $254,000

CM Ratio = (127,000/254,000) x 100 = 50%

Break-even point in unit sales –

Break-even point in unit sales = fixed cost/contribution margin per unit

Contribution margin per unit = $127,000/12,700 units = $10

Fixed cost = $142,000

Break-even point in units sales = 142,000/10 = 14,200 units

Break-even point in dollar sales –

Break-even point in dollar sales = fixed cost/CM ratio

= $142,000/50% = $284,000

2. Determination of the increase or decrease in the company’s monthly net operating income –

increase in fixed cost (advertising budget) = $6,200,

revised fixed cost = 142,000 + 6,200 = $148,200

Increase in monthly sales = $90,000

Revised sales = $254,000 + $90,000 = $344,000

Contribution margin = 50% of sales = $344,000 x 50% = $172,000

Net operating income = contribution margin – fixed cost

      = $172,000 – 148,200 = $23,800

Original net operating income = ($15,000)

Revised net operating income = $23,800

Change = 23,800 – (15,000) = 23,800 + 15,000 = $38,800

Hence, net operating income increased by $38,800

3. Determination of revised net operating income:

Sales price reduced by 10%, = $20 -10% $20 = $18

Revised fixed cost (with increased advertising expenditure) = $142,000 + $31,000 = $173,000

Revised unit sales = 2 x 12,700 = 25,400 units

Revised contribution margin = revised sales – revised variable cost

Revised sales = $18 x 25,400 units = $457,200

Revised variable cost = $10 x 25,400 units = $254,000

Revised CM = 457,200 – 254,000 = 203,200

Revised CM per unit = $203,200/25,400 units = $8 per unit

Revised net income = Revised CM – Revised fixed expenses

      = $203,200 - $173,000 = $30,200

Hence, revised net income = $30,200

4. Determination of number of units to be sold to reach monthly target of $4,900:

Revised variable cost = $10 + $0.80 = $10.80 per unit

Revised CM per unit = $20 - $10.80 = $9.20

Fixed expenses = $142,000

Target income = $4,800

Desired sales units = (fixed expenses + target profit)/CM per unit

      = (142,000 + 4,800)/9.20 = 15,956 units

Hence, the company needs to produce and sell 15,956 units to reach the target profit of $4,800.

5. A. New CM ratio and break-even point in unit sales and dollars:

Break-even point in unit sales -

Revised variable cost = $10 - $3 = $7 per unit

New CM per unit = $20 – 7 = $13

New CM ratio = new CM per unit/sales price per unit

      = (13/20) x 100 = 65%

Revised Fixed expenses = 142,000 + 60,000 = $202,000

Break-even point in unit sales = fixed expenses/CM per unit

      = $202,000/$13 = 15,538 units

Break-even point in dollar sales = fixed expenses/CM ratio

      = 202,000/65% = $310,769

5B      

	Contribution margin income statements
		Automation			No Automation
	Per Unit	Total	Percentage	Per Unit	Total	Percentage
Sales units		20,200			20,200
Sales	$20	$404,000	100%	$20	$404,000	100%
Variable cost	$7	$141,400	35%	$10	$202,000	50%
Contribution margin	$13	$262,600	65%	$10	$202,000	50%
Fixed expenses		$202,000	50%		$142,000	35.10%
Net Income		$60,600	15%		$60,000	14.90%

5c.

yes, we do recommend the company adopt automation.

Automation results in a marginal increase in net income by $600 (60,600 – 60,000). Though automation increases net operating income by only $600, the contribution margin ratio increases by 15%. This is because though automation increases fixed expenses by $60,000 it causes a reduction of $3 per unit in variable costs. Automation at 20,200 units would not be so profitable for the company, however if the production and sales increases, the company would be able to optimise the increase in fixed cost. Hence, automation is recommended.