Question

ADI produces memory enhancement kits for NUY Microwaves. Sales of the kits have been very erratic, with some months showing a profit and some months showing a loss. Currently, the ADI produces as many units as are required for sales. The ADI's contribution margin income statement for the most recent month is given below:
Sales (13,500 units at $20 per unit)
$270,000
Variable expenses (all production related)
189,000
Contribution margin
81,000
Fixed expenses (all production related)
90,000
Net operating loss
$ (9,000)
REQUIRED:
1. Compute the ADI’s CM ratio and its break-even point in units only.
2. Refer to the original data. By automating, ADI could slash its unit variable cost in half. However, fixed costs would increase by $118,000 per month.
(i) At what volume level would the division be indifferent between automation and the current non-automated process? That is, what is the ADI rule for automation in terms of volume?
(ii) Based on the decision rule above, would you recommend that the ADI automate its operations if volume continues at the current level?
8
(iii) Assume for this part that the selling price per kit is $24 per unit. All other data are the same as stated in the problem. What is the Operating Leverage Ratio (OLR)? If sales decline by 10%, what does the OLR predict will be the effect on operating income?
(iv) Assume just for this part only that production of memory kits is increased to 15000 units. However, sales are still 13,500 units. All other data are the same as stated in the problem. What would be the ADI’s reported income under Absorption Costing?

Answer 1

		Unit	rate $	value ($)
1	Sales	13500	20	270000
	variable expenses			189000
	Contribution margin			81000
	fixed expenses			90000
	Net operating loss			-9000
	CM Ratio			30%
	CM Ratio = (Sales- variable cost)/Sales
	Break even point = Fixec expenses/(Selling price-variable cost price)
	90000/(20-(189000/13500))			15000	Units
	90000/(20-14)
2(i)	Present variable cost	189000/13500		14
	After autmation variable cost	14/2		7
	Fixed cost incresed to	90000+118000		208000
	Now
	Break even point = Fixed expenses/(Selling price-variable cost price)	208000/(20-7)		16000
	Calculation will be :
	Sales 16000x20			320000
	Variable cost 16000x7			112000
	Contribution margin(sales- variable cost)			208000
	Fixed cost			208000
	Net profit			0
	So the automation in terms of minimum volume for BEP should be			16000
	Note: we are considering BEP level and not at Net operating loss of $ 9000 which is given below:
	Existing Operating loss			-9000
	Fixed expenses (New)			208000
	Net			199000
	Fixed expenses/(Selling price-variable cost price)	199000/(20-7)		15307.69
	Calculation will be:
	Sales 15307.69x20			306153.8
	Variable cost 15307.69x7			107153.8
	Contribution margin(sales- variable cost)			199000
	Fixed cost			208000
	Net profit			-9000
	So the automation in terms of minimum volume for above existing method			15307.69
2(ii)	Based on the above data it is not advisable to impliment ADI automate at its current level
8(iii)	Assume that Selling price per kit $ 24			$	sales decline by 10%	$
	Sales	13500	24	324000	12150	291600
	Variable cost	13500	14	189000	12150	170100
	Fixed Expenses			90000		90000
	Net operating income			45000		31500
	Operating leverage ratio =fixed cost/Total cost			32%		35%
	When sales is 13500 unit OLR will be 32% and net operating income will be $ 45000. When sales decline by 10%, OLR will be 35% and
	Net operating income will be $ 31500