Question

3-11 CVP analysis (LO 3)

Carr Orthotics Company distributes a specialized ankle support that sells for $30. The company’s variable costs are $18 per unit; fixed costs total $360,000 per year.

Required

a.    If sales increase by $39,000 per year, by how much should operating income increase?

b.    Last year, Carr sold 32,000 ankle supports. The company’s marketing manager is convinced that a 10% reduction in the sales price, combined with a $50,000 increase in advertising, will result in a 25% increase in sales volume over last year. Should Carr implement the price reduction? Why or why not?

Answer 1

(a) – Increase in Operating Income

Contribution per unit = Selling price per unit – variable cost per unit

= $30 – 18

= $12 per unit

Contribution Margin Ratio = [Contribution per unit / Selling price per unit] x 100

= [$12 / $30] x 100

= 0.40 or

= 40%

If the sale is increased by $39,000, then the Operating Income will increase by $15,600 [$39,000 x 40%]. The fixed costs shall not be considered here, since the fixed costs will not change in case of increase or decrease in the sales volume.

(b) – Implementation of Price Reduction

Net Operating Income before implementing the price reduction

Net Operating Income = Sales – variable costs – Fixed costs

= [32,000 units x $30] – [32,000 units x $18] - $360,000

= $960,000 – 576,000 – 360,000

= $24,000

Net Operating Income after implementing the price reduction

Net Operating Income = Sales – variable costs – Fixed costs

= [(32,000 units x 125%) x ($30 x 90%)] – [(32,000 units x 125%) x ($18 x 90%)] – [$360,000 + 50,000]

= $10,80,000 - 648,000 – 410,000

= $22,000

DECISION

NO. Carr Orthotics Company should not implement the price reduction, since there will be a reduction in their net operating income of $2,000 ($24,000 – 22,000) if the company implements the price reduction policy.