Question

Due to the sluggish economy, the Iguodala Company has experienced some difficulty in selling its bicycles. The following data relate to the current year:

Sales (9,000 Units @ $100/unit)	$900,000
Less variable costs (9,000 @ $60/unit)	$540,000
Contribution margin	$360,000
Less fixed costs	$400,000
Net operating loss	($40,000)

a. Compute Iguodala’s annual breakeven point, in both units and dollars. Also, compute the contribution margin ratio.

b. The manager believes that a $40,000 increase in advertising would result in a $120,000 increase in annual sales. If the manager is right, what will be the net effect on the company's operating income?

c. Refer to the original data. The vice-president in charge of sales is certain that a 10% reduction in selling price in combination with a $30,000 increase in advertising will cause sales volume to increases by 50%. What effect would this strategy have on operating income of the company?

d. Refer to the original data. In the following year, Iguodala saved $5 of total variable costs per bicycle by buying parts from a different manufacturer. However, Iguodala’s rent and insurance increased by $5,600. The store sold 11,000 bikes. What was its operating income for the year?

Answer 1

Solution

Iguodala Company

1. Computation of the annual breakeven point in both units and dollars as well as the contribution margin ratio:

Contribution margin ratio –

Contribution margin ratio = contribution margin/sales

Contribution margin = $360,000

Sales = $900,000

Contribution margin ratio = $360,000/$900,000 = 40%

Break-even point:

• In unit sales = fixed cost/ contribution margin per unit

Contribution margin per unit = $360,000/9,000 = $40 per unit

Fixed cost = $400,000

Break-even point in unit sales = $400,000/$40 = 10,000 units

Break-even point:

In dollar sales = fixed cost/Contribution margin ratio

Fixed cost = $400,000

Contribution margin ratio = 40%

Break-even point in dollar sales = $400,000/40% = $1,000,000

1. Determination of net effect of $40,000 increase in advertising and $120,000 increase in sales on the company’s operating income:

Increase in sales = $120,000

Incremental increase in contribution margin = $120,000 x 40% = $480,000

Less: Additional fixed cost = $40,000

Net operating income = $440,000

Original net operating income/(Loss) = -$40,000

Hence increase = $440,000 – ($40,000)= $480,000

Hence, Net income increases with increase in advertising expense and sales.

1. Sales price reduced by 10% -

= $100 -10% = $90

Advertising expense = $30,000

Increase in sales volume = 50% = 9,000 + 50% = $13,500

Revised contribution margin per unit = $90 - $60 = $30 per unit

Revised fixed expenses = $400,000 + $30,000 = $430,000

Contribution margin income statement with revised changes:

     

Sales	13,500 units at $90 per unit	$1,215,000
Variable costs	at $60 per unit	$810,000
Contribution margin		$405,000
Fixed expenses		$430,000
Net income/(loss)		($25,000)

               

Hence, the effect of the proposed changes on net income is that the changes tend to lower net income.

1. Savings in variable cost = $5 = $60-$5 =$55

Increase in rent and insurance = $5,600

Sales = 11,000 bikes

Operating income

Sales	11,000 units x $100	$1,100,000
Variable costs	$55	$605,000
Contribution margin		$495,000
Fixed expenses	$400,000
Add: rent and insurance	$5,600	$405,600
Net Income		$89,400

Hence the operating income when the variable cost reduces by $5 per unit and fixed cost increase by $5,600 would be $89,400.

The company reports net income of $89,400 for all sales above the break-even level of 10000 units.