Question

Case: Cost Structures for Global Shippers Inc.

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) Calculation of Break even Point :-

Formula for Break even Point :-

Break even Point = Fixed Cost Contribution per unit

(i) Calculation of Break even Point for Option A:-

Break even Point =   $ 1200000 15

= 80000 Shipments.

(ii) Calculation of Break even Point for Option B:-

Break even Point =   $ 4500000 40

= 112500 Shipments.

(2) Calculation of Shipments to Produce Operating Income of $ 30000 under Option A :-

Formula to Calculate No of Shipments to Produce Operating Income of $ 30000 -

= (Fixed Cost + Operating Income)   Contribution per unit

= ( $ 1200000 + $ 30000 ) 15

= 82000 Shipments

(3) Calculation of shipments per year to be made under Option A to produce an operating margin equal to 9% of Sales revenue ;-

Let the Shipments be x

Then, Sales Revenue be 100x

Contribution be 15x

Operating Margin be 9x

so, the equation would be :-

15x - 1200000 = 9x

x = 200000 Shipments

So, the Answer is 200000 Shipments.

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

Net income to be Earned before tax would be :-

$180000 0.6 = $300000.

Calculation of Shipments to earn income of $300000 would be :-

= (Fixed Cost + Operating Income)   Contribution per unit

=(4500000 + 300000 ) 40

= 120000 Shipments

So,120000 Shipments is required under Option B to produce net income of $180,000 per year, given a corporate tax rate of 40%.