Question

Nathan and Cody notice there is stiff competition in the food cart and food truck industries and therefore are considering opening a traditional restaurant. Opening a restaurant would have many advantages and disadvantages, the company can expect fixed costs to increase by $140,000 a year to cover rent, equipment, furniture, salaries and other costs.

This alternative is exclusive of alternative 1 -so use the original financial information from page 1 (also shown below) to calculate the effects of opening a restaurant.

Sales	$217,875.00
Variable costs	46,687.50
Contribution margin	171,187.50
Fixed costs	90,000.00
Income before taxes	81,187.50
Income taxes (32% rate)	25,980.00
Net income	55,207.50

Additional information:

This alternative would allow GT to increase their plate prices to $14.50 and would increase the variable cost per unit by $2.50. Assume plate sales remain at 31,125.

1. Compute the company's new contribution margin under this alternative. Compute the contribution margin both in total dollars and per unit.

2. Compute the company's contribution margin ratio under both scenarios. (Note: Do not round the CMR for accurate calculations in the following questions).

3. Compute the break-even point in sales dollars under each scenario. How many plates will need to be sold under each situation to break-even?

4. Compute the operating leverage under each scenario.

  

5. If the company wishes each scenario, food cart and restaurant, to generate net income (after-tax) of $170,000, what is the amount of sales that needs to be generated? How many plates will need to be sold? Prepare a contribution margin statement for this step and verify that your after-tax net income in fact equals $170,000 for both the food cart and restaurant.

6.Assume that the company expects sales to decline by 20% next year. There will be no change in plate price. Prepare forecasted financial results for next year following the format of the contribution margin income statement as shown above with columns for each of the two types (assume a 32% tax rate, and that any loss before taxes yields a 32% tax savings).

7. Assume that the company expects sales to increase by 20% next year. There will be no change in plate price. Prepare forecasted financial results for next year following the format of the contribution margin income statement as show above with columns for each of the two types (assume 32% tax rate, and that any loss before taxes yields a 32% tax savings).

8. Compute the profit Margin and Return on Assets for each scenario assuming average total assets of $1,000,000. Industry averages are 12% and 5% respectively.

Please show all work. Thank you.

Answer 1

Solution

Nathan and Cody

1. Computation of the company’s new contribution margin under the alternative – with unit sales price = $14.50 and unit variable cost = $4

Unit Contribution margin = unit sales price – unit variable cost

Unit contribution margin = $14.50 - $4 = $10.50

Contribution margin total = unit contribution margin x number of plate sales

Number of plate sales = 31,125

Contribution margin, total = $10.5 x 31,125 = $326,812.50

Note : Original variable cost per plate = $46,687.50/31,125 = $1.50

The increase in variable cost per plate = $2.50

Hence unit variable cost = $1.50 + $2.50 = $4

1. Computation of contribution margin ratio under both the scenarios:

Original contribution margin ratio –

Original sales price per plate = $217,875/31,125 = $7

Original variable cost per plate = $46,687.50/31,125 = $1.50

Original contribution margin = $7 - $1.50= $5.50

Original contribution margin ratio = $5.50/$7 = 78.57%

Contribution margin ratio under the alternative 1,

Sales price = $14.50 per plate

Contribution margin = $10.50 per plate (calculated in 1. Above)

Contribution margin ratio = $10.5/$14.50 = 72.41%

1. Computation of break-even point in sales dollars under each scenario:

Original data –

Fixed cost = $90,000

Contribution margin ratio = 78.57%

Break-even sales in dollars = fixed cost/contribution margin ratio

= $90,000/78.57% = $114,545.50

Break-even sales in plates = fixed cost/contribution margin per plate

Contribution margin per plate = $5.50

Break-even sales in plates = $90,000/$5.50 = 16,363.63 = 16,364 plates (rounded)

Alternative 1 –

Fixed cost increases by $140,000, hence revised fixed cost = $90,000 + $140,000 = $230,000

Contribution margin ratio = 72.41%

Break-even sales in dollars = Fixed cost/contribution margin ratio

= $230,000/72.41% = $317,619

Break-even sales in plates = fixed cost/contribution margin per plate

Contribution margin per plate = $10.50

Break-even sales in plates = $230,000/$10.50 = 21,904.76 = 21,905 plates (rounded)

1. Computation of operating leverage under each scenario –

Operating leverage under original scenario:

Operating leverage = contribution/net income

Contribution margin = $171,187.50

Net income = $55,207.50

Operating leverage = 171,187.50/55,207.5 = 3.10

Operating leverage under alternative 1:

Operating leverage = contribution/net income

Contribution margin = $10.5 x 31,125 = $326,812.50

Net income –

Sales	$451,312.50
Variable cost	$124,500
Contribution margin	$326,812.50
Fixed cost	$230,000
income before taxes	$96,812.50
income tax at 32%	$30,980
net income	65,832.50

Operating leverage = 326,812.50/65,832.50 = 4.96

1. Assuming target net income (after tax) for each scenario is $170,000

Original data –

Desired sales = (fixed cost + target income + income taxes)/contribution margin per plate

= (90,000 + 170,000+ 25,980)/5.50 = 51,996.4 = 51,996 plates (rounded)

Alternative 1 –

Desired sales = (fixed cost + target income + income taxes)/contribution margin per plate

= (230,000 + 170,000 + 15,024)/10.50 = 39,526.09 = 39,526 plates (rounded)

1. Contribution format income statement showing scenarios of original and 20% sales decline:

	original	sales decline by 20%
Sales	$217,875	$174,300
Variable cost	$46,687.50	$37,350
Contribution margin	171,187.50	$136,950
Fixed cost	$90,000	$90,000
income before taxes	$81,187.50	$46,950
income tax at 32%	$25,980	$15,024
net income	$55,207.50	$31,926

1. Contribution format income statement showing scenarios of original and 20% sales increase:

	original	Sales increase by 20%
Sales	$217,875	$261,450
Variable cost	$46,687.50	$56,025
Contribution margin	171,187.50	$205,425
Fixed cost	$90,000	$90,000
income before taxes	$81,187.50	$115,425
income tax at 32%	$25,980	$36,936
net income	$55,207.50	$78,489

1. Computation of profit margin and return on assets:

Profit margin = net income/sales

Return on assets =net income/total assets

	original	Alternative 1
invested assets	$1,000,000	$1,000,000
Sales	$217,875	$451,312.50
net income	$55,207.50	$65,832.50
profit margin	25.33%	14.59%
Industry Average	12%	12%
Return on Assets	5.50%	6.60%
Industry Average	5%	5%