Question

You are considering buying one of two local firms (Olson Corporation and Miami Inc.) Olson Corporation uses a substantial amount of direct labor in its manufacturing operations, and its salespeople work on commission. Miami Inc. uses the latest automated technology in manufacturing; its salespeople are salaried. The following financial information is available for the two companies:

                                                            OLSON CORP.                     MIAMI INC._______    

                                                   2013                 2014                             2013                   2014

     Sales                                   $ 600,000       $ 960,000          $ 600,000      $     840,000

     Expenses including taxes      (528,000)        (823,200)            (528,000)           (667,200)                       

            Net Income                 $    72,000      $ 136,800        $     72,000      $    172,800    

                       

After examining cost data, you find that the fixed cost for Olson Corporation is $60,000; the fixed cost for Miami Inc. is $300,000. The tax rate for both companies is 40 percent.

a.     Recast the income statements into a variable costing format.

b.     What are the break-even sales for each firm for each year? (Round to the next highest whole dollar.)

c.     Assume that you could acquire either firm for $1,200,000, and you want an after tax return of 12 percent on your investment. Determine what sales level for each firm would allow you to reach your goal.

d.     What is the margin of safety for each firm for each year? What is the degree of operating leverage?

e.     Assume that product demand for 2015 is expected to rise by 15 percent from the 2014 level. What will be the expected net income for each firm?

f.     Assume that product demand for 2015 is expected to fall by 20 percent from the 2014 level. What will be the expected net income for each firm?

                       

Answer 1

	a	RECASTING INCOME STATEMENT INTO A VARIABLE COSTING FORMAT
			OLSON CORP.
				2,013	2014
		A	Sales	$600,000	$960,000
		B	Net Income after tax	$72,000	$136,800
		C	Tax rate(40%)	0.40	0.40
		D=B/(1-C)	Before tax income	$       120,000	$        228,000
		E=A-D	Expenses excluding tax	$480,000	$732,000
		F	Fixed cost	$60,000	$60,000
		G=E-F	Variable cost	$420,000	$672,000
			MIAMI INC
				2,013	2014
		A	Sales	$600,000	$840,000
		B	Net Income after tax	$72,000	$172,800
		C	Tax rate(40%)	0.40	0.40
		D=B/(1-C)	Before tax income	$       120,000	$        288,000
		E=A-D	Expenses excluding tax	$480,000	$552,000
		F	Fixed cost	$300,000	$300,000
		G=E-F	Variable cost	$180,000	$252,000
			INCOME STATEMENT
				OLSON CORP		MIAMI INC
				2013	2014	2013	2014
		H	Sales	$600,000	$960,000	$600,000	$840,000
		I	Variable Costs	$420,000	$672,000	$180,000	$252,000
		J=H-I	Contribution margin	$180,000	$288,000	$420,000	$588,000
		K	Fixed costs	$60,000	$60,000	$300,000	$300,000
		L=J-K	Income before taxes	$120,000	$228,000	$120,000	$288,000
		M=0.4*L	Taxes	$48,000	$91,200	$48,000	$115,200
		N=L-M	Net Income	$72,000	$136,800	$72,000	$172,800
	b	BREAKEVEN SALES
		P=J/H	Contribution margin ratio	0.3	0.3	0.7	0.7
		Q=K/P	Breakeven Sales	$200,000	$200,000	$428,571	$428,571
	c.	R	Cost of acquiring	$1,200,000
		S	Required return (12%)	0.12
		T=R*S	Amount of return required(after tax)	$144,000
			Before tax return required	$240,000	(144000/(1-0.4)
				OLSON CORP		MIAMI INC
				2013	2014	2013	2014
		U	Breakeven Sales	$200,000	$200,000	$428,571	$428,571
		V	Contribution margin ratio	0.3	0.3	0.7	0.7
		W	Before tax profit required	$240,000	$240,000	$240,000	$240,000
		X=W/V	Sales beyond Breakeven level required	$800,000	$800,000	$342,857	$342,857
		Y=U+X	Required sales Level	$1,000,000	$1,000,000	$771,429	$771,429
				OLSON CORP		MIAMI INC
				2013	2014	2013	2014
	d	MARGIN OF SAFETY
		H-U	Margin of Safety(sales-Breakeven level)	$400,000	$760,000	$171,429	$411,429
		OPERATING LEVERAGE=(Contribution margin)/(Income before taxes)
				OLSON CORP		MIAMI INC
				2013	2014	2013	2014
		J/L	Operating leverage	1.5	1.263157895	3.5	2.041667
	e	PRODUCT DEMAND INCREASES BY 15%
				OLSON CORP	MIAMI INC
			EXPECTED IN 2015	2015	2015
		H	Sales	$1,104,000	$966,000
		I	Variable Costs	$772,800	$289,800
		J=H-I	Contribution margin	$331,200	$676,200
		K	Fixed costs	$60,000	$300,000
		L=J-K	Income before taxes	$271,200	$376,200
		M=0.4*L	Taxes	$108,480	$150,480
		N=L-M	Net Income	$162,720	$225,720
	f	PRODUCT DEMAND DECREASES BY 20%
				OLSON CORP	MIAMI INC
			EXPECTED IN 2015	2015	2015
		H	Sales	$768,000	$672,000
		I	Variable Costs	$537,600	$201,600
		J=H-I	Contribution margin	$230,400	$470,400
		K	Fixed costs	$60,000	$300,000
		L=J-K	Income before taxes	$170,400	$170,400
		M=0.4*L	Taxes	$68,160	$68,160
		N=L-M	Net Income	$102,240	$102,240