Question

Rundle Company is considering the addition of a new product to its cosmetics line. The company has three distinctly different options: a skin cream, a bath oil, or a hair coloring gel. Relevant information and budgeted annual income statements for each of the products follow.

	Relevant Information
	Skin Cream				Bath Oil				Color Gel
Budgeted sales in units (a)		126,000				206,000				86,000
Expected sales price (b)	$	8			$	6			$	13
Variable costs per unit (c)	$	2			$	4			$	9
Income statements
Sales revenue (a × b)	$	1,008,000			$	1,236,000			$	1,118,000
Variable costs (a × c)		(252,000	)			(824,000	)			(774,000	)
Contribution margin		756,000				412,000				344,000
Fixed costs		(576,000	)			(320,000	)			(108,000	)
Net income	$	180,000			$	92,000			$	236,000

  
Required:

Determine the margin of safety as a percentage for each product.

Prepare revised income statements for each product, assuming a 20 percent increase in the budgeted sales volume.

For each product, determine the percentage change in net income that results from the 20 percent increase in sales.

Which product has the highest operating leverage?

Assuming that management is pessimistic and risk averse, which product should the company add to its cosmetics line?

Assuming that management is optimistic and risk aggressive, which product should the company add to its cosmetics line?

Answer 1

Compution of Margin of safety as percentage of each produt

S.no	Products	Computation	Mos on sales valum	Percentage of Mos on sales
1	Skin	Mos=Net incomeContribution per unit	30,000units (1,80,0006)	23.80% (30,0001,80,000)
2	Bath oil	Mos=Net incomeContribution per unit	46000units (92,0002)	22.33% (46000206000)
3	Color Gel	Mos=Net incomeContribution per unit	59000units (2360004)	68.60% (5900086000)

Preparation of revised income statement(sales valume incresed by 20%)

Particulars	Skin oil	Bath oil	Color Gel
Sales Revenue	1209600 (151200*8)	1483200 (247200*6)	1341600 (103200*13)
Less: Varaible Cost (Sales units * vararaible cost per unit)	302400	988800	928800
Contribution	907200	494400	412800
Less: Fixed Cost	576000	320000	108000
Net income	331200	174400	304800

Percentage change in net income that results from the 20% increase in sales

Particulars	Skin oil	Bath oil	Color Gel
Net income	180000	92000	236000
Net inome(after 20% increase in sales)	331200	174400	304800
Percentage in net income	84%	89.56%	29.15%

Computation of degree of operating leverage

Particulars	Skin oil	Bath oil	Color gel
Contribution	756000	412000	344000
Net income	180000	92000	236000
Dol=ContributionNet income	4.2 times	4.48 times	1.46 times

Since from the above Product Bath oil has highest Operating leverage

Assuming that management is pessimistic and risk averse, then it should add its cosmetics line in Product Bath oil, because the risk is more as per Operating leverage Ratios

Assuming that management is optimistic and risk aggressive, then it should go for Color gel product line to add its cosmetics, Because in which the risk is very low as compared to other product line as well as it gives good returns too as compared to other product lines.

Always Low Operating leverage is pereferable and increased returns/incomes.