Question

Using cost-volume-profit formuas:E 20.8 Arrow products typically earns a contribution margin ratio of 25 percent and has current fixed cost of $80,000. Arrow's general manger is considering spending an additional $20,000 to do one of the following : 1 start a new ad campaign that is expected to increase sales revenue by 5 percent. 2. license a new computerized ordering system that is expected to increase Arrow's contribution margin ratio to 30 percent. sales revenue for the coming year was initially forecast to equale $1,2000,000(that is without impleminting either of the above options). A. For each option, how much will projected operating income increase or decrease relative to initial prediction? B. By what percentage would sales revenue need to increase to make the ad campaign as attractive as the ordering system?

Answer 1

A.

Let us first calculate operating income under each of the options:

Increase/(Decrease) in operating income = Operating Income under new option - Operating Income under Initial Forecast

For Option 1 = 215,000 - 2,20,000

= -5,000 or 5,000 decrease

For Option 2 = 260,000 - 220,000

= 40,000 increase

B. In order to make the ad campaign as attractive as the ordering system, operating income under ad campaign should be equal to operating income under ordering system.

Therefore, required operating income = 260,000

By back calculation, required contribution margin = Operating income + Fixed Costs

= 260,000 + 100,000

= 360,000

Let required sales be Y

Threfore, Contribution Margin = Sales x Contribution Margin %

360,000 = Y x 25%

or Y = 360,000 / 25%

or Y = 1,440,000

Therefore, required sales revenue = $1,440,000

Increase in sales revenue over initial forecast = 1,440,000 - 1,200,000

= $240,000   

% increase = 240,000 / 1,200,000 x 100

= 20%

Therefore, Sales revenue need to increase by 20% to make the ad campaign as attractive as the ordering system