Question

Case: Cost Structures for Global Shippers Inc.

Management from Global Shippers Inc, an international shipping business, is in the process of assessing the choice between two different cost structures for the business. Option A has relatively higher variable costs per unit shipped but lower annual fixed costs, while Option B has the opposite—relatively lower variable costs in its cost structure but higher fixed costs. Assume that delivery selling prices per unit are constant. The table below contains critical information in making the decision:

Cost Information	Option A	Option B
Delivery price (revenue) per shipment	$100	$100
Variable cost per shipment delivered	$85	$60
Contribution Margin per unit	$15	$40
Fixed costs (annual)	$1,200,000	$4,500,000

Management wants you to write a professional report, answering the following questions:

Questions

Case: Cost Structures for Global Shippers Inc.

Management from Global Shippers Inc, an international shipping business, is in the process of assessing the choice between two different cost structures for the business. Option A has relatively higher variable costs per unit shipped but lower annual fixed costs, while Option B has the opposite—relatively lower variable costs in its cost structure but higher fixed costs. Assume that delivery selling prices per unit are constant. The table below contains critical information in making the decision:

Cost Information	Option A	Option B
Delivery price (revenue) per shipment	$100	$100
Variable cost per shipment delivered	$85	$60
Contribution Margin per unit	$15	$40
Fixed costs (annual)	$1,200,000	$4,500,000

Management wants you to write a professional report, answering the following questions:

Questions

1) What is the break-even point, in terms of volume (i.e., number of shipments per year), for Option A? Option B?

(2) How many shipments would have to be made under Option A to produce operating income of $30,000 for an annual period?

(3) How many shipments per year would have to be made under Option A to produce an operating margin equal to 9% of sales revenue?  

(4) How many shipments are required under Option B to produce net income of $180,000 per year, given a corporate tax rate of 40%?

(5) Assume that for the coming year total fixed costs are expected to increase by 15% for each of the two options. What is the new break-even point, in terms of number of shipments, for each option? By what percentage did the break-even point change for each case? How do these figures compare to the percentage increase in budgeted fixed costs?

(6) Assume an average income-tax rate of 20%. What volume (number of shipments) would be needed to generate net income of 5% of revenue for each option?  

(7) Which option do you think is the more profitable one for this business? Explain.

(8) Which option do you consider to be more risky to the business? Explain (calculate degree of operating leverage to help answer this question).

Answer 1

1. Break- even point in terms of Volume= Fixed Costs/Contribution Margin per unit

Option A = $1,200,000/$15 = 80,000 number of shipment per year

Option B = $4,500,000/$40 = 112,500 number of shipment per year

2. Number of shipments under Option A to produce operating income of $30,000

Number of Shipment = (Fixed Cost+ Desired Operating Income)/ Contribution Margin per unit

= ($1,200,000+$30,000)/$15 = $1,230,000/$15 = 82,000

82,000 Number of shipments required under Option A to produce operating income of $30,000.

3. Option A, Assume sales Quantity be "X"

Total Sales be $100X

Therefore , operating Margin = $100X* 9%= $9X

Total Sales - Total Cost = Operating Margin

$100X - $85X- $1,200,000 = $9X

$100X-$85X-$9X= $1,200,000

$6X = $1,200,000

X= $1,200,000/$6 = 200,000

So,200,000 shipments per year would have to be made under Option A to produce an operating margin equal to 9% of sales revenue.

4. Option B

Net Income After Tax = $180,000 Tax RAte = 40%

Net Income before tax = $180,000/60%= $300,000

Number of Shipment = (Fixed Cost+ Desired Operating Income)/ Contribution Margin per unit

= ($4,500,000+$300,000)/$40 = $4,800,000/$40 = 120,000

120,000 Number of shipments required under Option B to produce operating income of $180,000.

5. Fixed Cost in Option A = $1,200,000+$1,200,000*15%= $1,200,000+$180,000 = $1,380,000

Fixed Cost in Option B = $4,500,000+$4,500,000*15%= $4,500,000+$675,000 = $5,175,000

Break- even point in terms of Volume= Fixed Costs/Contribution Margin per unit

Option A = $1,380,000/$15 = 92,000 number of shipment per year

Option B = $5,175,000/$40 = 129,375 number of shipment per year

percentage the break-even point change for each case:-

Option A= (92,000-80,000)/80,000= 12,000/80,000 = 0.15 = 15%

Option B = (129,375-112,500)/112,500 = 16,875/112,500 = 0.15 = 15%

Break- even point changed in the same proportion in the proportion fixed cost changed/ increased.

6. Option A,

Assume sales Quantity be "X"

Total Sales be $100X

Therefore , operating Margin after tax= $100X* 5%= $5X

Operating Margin before tax = $5X/80% = $6.25X

Total Sales - Total Cost = Operating Margin after tax

$100X - $85X- $1,200,000 = $5X

$100X-$85X-$5X= $1,200,000

$10X = $1,200,000

X= $1,200,000/$10 = 120,000

So,120,000 shipments per year would have to be made under Option A to produce an operating margin equal to 5% of sales revenue.

Option B,

Assume sales Quantity be "X"

Total Sales be $100X

Therefore , operating Margin after tax= $100X* 5%= $5X

Operating Margin before tax = $5X/80% = $6.25X

Total Sales - Total Cost = Operating Margin after tax

$100X - $60X- $4,500,000 = $5X

$100X-$60X-$5X= $4,500,000

$35X = $4,500,000

X= $4,500,000/$35 = 128,571.42 = 128,572

So,128,572 shipments per year would have to be made under Option B to produce an operating margin equal to 5% of sales revenue.

7.