Question

A company produces and sells a product with the following information: Selling price per unit: $100 Variable cost per unit: $50 Fixed costs per month: $30,000 Expected sales volume per month: 1,000 units The company is considering a proposal to increase the selling price to $110 per unit, which is expected to reduce sales volume to 900 units per month. Alternatively, the company could reduce variable costs per unit to $45 by improving efficiency, which is expected to increase sales volume to 1,100 units per month. Which proposal should the company choose and why? Show your calculations to support your answer.

Answer 1

To determine which proposal the company should choose, we need to calculate the total contribution margin (total revenue minus total variable costs) for each scenario, and compare it to the fixed costs to determine the operating income. Scenario 1: Increase selling price to $110 per unit with sales volume of 900 units per month. Total revenue = $110 x 900 = $99,000 Total variable costs = $50 x 900 = $45,000 Contribution margin = $99,000 - $45,000 = $54,000 Operating income = Contribution margin - Fixed costs = $54,000 - $30,000 = $24,000 Scenario 2: Reduce variable cost to $45 per unit with sales volume of 1,100 units per month. Total revenue = $100 x 1,100 = $110,000 Total variable costs = $45 x 1,100 = $49,500 Contribution margin = $110,000 - $49,500 = $60,500 Operating income = Contribution margin - Fixed costs = $60,500 - $30,000 = $30,500 Comparing the two scenarios, we can see that the second proposal to reduce variable costs is more profitable, resulting in an operating income of $30,500, compared to the $24,000 from the first proposal to increase selling price. Therefore, the company should choose to reduce variable costs to $45 per unit by improving efficiency and increase sales volume to 1,100 units per month.

the company should choose to reduce variable costs to $45 per unit by improving efficiency and increase sales volume to 1,100 units per month.