Question

After working in an established law firm for a couple of years, Stephen Lee is considering opening a law office "Lee and Associates" to serve an under-serviced segment - the small and medium-sized enterprises.

This law office would provide easy access to clients with opening hours from 7am to 11pm (16 hours) everyday, 360 days a year. For each of two eight-hour shifts, a lawyer, paralegal, legal secretary and clerk-cum-receptionist will staff the office.

A marketing consultant was contracted to assist with market projections as part of the feasibility study. The consultant projected that if the firm spends $1,960,000 on advertising in the first year, the expected number of new clients each day would have the following probability distribution:

Stephen and his associates believed these numbers to be reasonable and were prepared to spend the $1,960,000 on advertising. Further information relating to the feasibility study were as follows:

- Each new client would be charged $120 for the initial consultation. The firm would also charge a contingency fee equivalent to 30 per cent of any favourable settlements or judgements on the cases that warrant further legal work. Stephen estimated that 20 per cent of new client consultations would result in favourable settlements or judgements averaging $8,000 each. He did not expect any repeat clients during the first year of operations.

- The hourly wages of the staff were budgeted as follows:

- Staff related costs would be 40 per cent of wages paid. 400 hours of overtime is expected for the year, which would be divided equally between the legal secretary and the clerk-cum-receptionist. Overtime would be paid at 1.5 times the regular wage, and the staff related costs would apply to total wages paid.

- Stephen had scouted for a suitable office of 6,000 square metres at an annual rent of $672,000. Management fees payable to the building owner was estimated at $108,000 and power and utilities at $148,000 annually.

- Professional indemnity insurance was expected to cost $720,000 annually.

- The capital investment in renovation and office equipment would be $300,000. Renovation and office equipment would be depreciated over its estimated useful life of five years, on a straight-line basis.

- Office supplies, including printing and stationery, was estimated to be $16 per new client consultation.

Required:

(a) Apply cost-volume-profit analysis to derive the breakeven number of clients for the firm's first year of operations.

(b) Using the probability information provided by the marketing consultant for year 1, analyse and show clear computations to explain whether it is feasible to open the law office.

(c) Calculate the firm's margin of safety in absolute terms ($) and in ratio. Provide your answers to 4 decimal places. Explain the implications of your computations to the firm.

(d) There are a number of key assumptions underlying the cost-volume-profit model. Explain how two (2) of these assumptions are applicable to your analysis for the firm.

Answer 1

Part (a)

Calculation of Average no of clients per day
Number of clients	Probability	Expected no of clients
20	0.1	2
40	0.1	4
50	0.4	20
60	0.4	24
Average no of clients per day	50

No of days working per year		360
Average no of clients per year(360*50)		18000

Total hours work per day	16 hours
Staff	Rate per hour	Total hours per year(16*360)	Total wages
Lawyer	100	5760	576000
Paralegal	80	5760	460800
Legal secretary	60	5760	345600
Clerk -cum-receptionist	40	5760	230400
Total	1612800
Overtime hour	400 hour
Overtime hour distributed equally between legal secretary and clerk
Overtime wage rate is 150% of usual wage rate
Legal secretary	(60*150%)=90	200	18000
Clerk -cum-receptionist	(40*150%)=60	200	12000
Total	30000
Total wages paid including overtime (1612800+30000)	1642800
Staff related cost is 40% of total wages
Hence it is (1642800*40%)		657120

Consultation fee per client	120
Average no of clients per year(360*50)	18000
Total consultation fee	2160000
Contigency fee
It is given that 20% of new consultation results in favourable settlement or judgement
Therfore it is	3600 clients
Amount of favourable settlement per client	8000
Total amount(8000*3600)		28800000
Contigency fee is 30% on 28800000	8640000
Therefore total income(2160000+8640000)	10800000
Average revenue per client (10800000/18000)	600
Calculation of Variable cost per client
Office supplies cost per client is	16
Wages (1642800/18000)	91.27
Staff related cost (657120/18000)	36.51
Total	143.77

Fixed cost
Annual rent	672000
Management fee	108000
Power and utilities	148000
Professional indemnity insurance	720000
Depreciation (300000/5 years)	60000
Total Fixed cost	1708000
Contribution per client (600-143.77)	456.23
Break even no of clients is
(Fixed cost/contribution per client)	3744

Part(b)

Using the probabilty information it can say the it is feasible to open the law office.Because the probability information provides that,the average no of client is 18000 per year at the same time the required no of client to break even is only 3744.if the office is opened it can make profit out of 14256 (18000-3744) clients

Part(c)

Calculation of Margin of Safety
MOS=Actual sales-Break even sales
Actual sales (18000*600)	10800000
Break even sales (3744*600)	2246400
MOS	8553600
MOS in ratio (8553600/10800000)*100	79.20%
MOS is the profit which the firm going to get after meeting all the fixed cost.Any revenue which the firm gets after 3744 client,is attributable to the profit of the firm.Hence Revenue which the firm acquire for 14256 clients completely added to the profit of the firm

Part(d)

Assumptions of Cost Volume Profit Analysis
1	Consultant fee is constant per client
	The average fee charged per client is constant and changes only with number of clients
2	Change in the number of clients only affect the cost