Question

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

		Hawaiian Fantasy	Tahitian Joy
	Selling price per unit	$20.00	$25.00
	Variable expenses per unit	$14.00	$10.00
	Number of units sold annually	25,000	10,000

Fixed expenses total $270,000 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:

a. Prepare a contribution format income statement showing both dollar and percent columns for each product and for the company as a whole.

b. Compute the break-even point in dollars for the company as a whole and the margin of safety in both dollars and percent.

2. The company has just developed a new product to be called Samoan Delight. Assume that the company could sell 12,000 units at $17.50 each. The variable expenses would be $14.00 each. The company’s fixed expenses would not change.

a. Prepare another contribution format income statement, including sales of the Samoan Delight (sales of the other two products would not change).

b. 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

Requirement 1a: Prepare contribution format income statement as follows

Particulars	Product HF	Product TJ	Total
Amount	Percent	Amount	Percent	Amount	Percent
Sales (25,000 × $20 : 10,000 × $25 )	$500,000	100%	$250,000	100%	$750,000	100%
Variable expenses (25,000 × $14 : 10,000 × $10 )	$350,000	70%	$100,000	40%	$450,000	60%
Contribution margin	$150,000	30%	$150,000	60%	$300,000	40%
Fixed expenses					$270,000
Net operating income					$30,000

Requirement 1b: Compute break-even point and margin of safety dollars and percentage as follows

Particulars	Amount
Fixed expenses	$270,000
÷ Contribution margin ratio	40%
Break-even sales in dollars	$675,000
Particulars	Amount
Actual sales revenue	$750,000
Deduct: Break-even sales	$675,000
Margin of safety in dollars	$75,000
÷ Actual sales revenue	$750,000
Margin of safety percentage	10%

Requirement 2a: Prepare contribution format income statement as follows

Particulars	Product HF	Product TJ	Product SD	Total
Amount	Percent	Amount	Percent	Amount	Percent	Amount	Percent
Sales (25,000 × $20 : 10,000 × $25 : 12,000 × $17.50)	$500,000	100%	$250,000	100%	$210,000	100%	$960,000	100%
Variable expenses (25,000 × $14 : 10,000 × $10 : 12,000 × $14)	$350,000	70%	$100,000	40%	$168,000	80%	$618,000	64%
Contribution margin	$150,000	30%	$150,000	60%	$42,000	20%	$342,000	36%
Fixed expenses							$270,000
Net operating income							$72,000

Requirement 2b: Compute break-even point and margin of safety dollars and percentage as follows

Particulars	Amount
Fixed expenses	$270,000
÷ Contribution margin ratio	36%
Break-even sales in dollars	$757,895
Particulars	Amount
Actual sales revenue	$960,000
Break-even sales	$757,895
Margin of safety in dollars	$202,105
÷ Actual sales revenue	$960,000
Margin of safety percentage	21%

Requirement 3:

The average contribution margin ratio decreased to 36% from 40% whan a new product is added and as a result break-even sales increased to $757,895 from 675,000. The decrease in average contribution margin is the result of adding lower contibution margin product. Even though break-even sales increased, it should be noted that the margin of safety of also incresed to 202,105 from 75,000.