Question

Due to erratic sales of its sole product—a high-capacity battery for laptop computers—PEM, Inc., has been experiencing difficulty for some time. The company’s contribution format income statement for the most recent month is given below: Sales (19,500 units × $30 per unit) $ 585,000

Variable expenses 409,500
Contribution margin 175,500
Fixed expenses 180,000
Net operating loss $ (4,500)
Required:
1.Compute the company’s CM ratio and its break-even point in both unit sales and dollar sales.
2. The president believes that a $16,000 increase in the monthly advertising budget, combined with an intensified effort by the sales staff, will result in an $80,000 increase in monthly sales. If the president is right, what will be the effect on the company’s monthly net operating income or loss? (Use the incremental approach in preparing your answer.)
3. Refer to the original data. The sales manager is convinced that a 10% reduction in the selling price, combined with an increase of $60,000 in the monthly advertising budget, will double unit sales. What will the new contribution format income statement look like if these changes are adopted?
4. Refer to the original data. The Marketing Department thinks that a fancy new package for the laptop computer battery would help sales. The new package would increase packaging costs by 75 cents per unit. Assuming no other changes, how many units would have to be sold each month to earn a profit of $9,750? (Do not round intermediate calculations.)
5. Refer to the original data. By automating, the company could reduce variable expenses by $3 per unit. However, fixed expenses would increase by $72,000 each month.

a.
Compute the new CM ratio and the new break-even point in both unit sales and dollar sales. (Use the CM ratio to calculate your break-even point in dollars.)

b.
Assume that the company expects to sell 26,000 units next month. Prepare two contribution format income statements, one assuming that operations are not automated and one assuming that they are.

c.
Would you recommend that the company automate its operations?

Answer 1

1. The CM ratio is 30% and the break-even point is 18,000 units or $540,000 in dollar sales.
2. If the monthly sales increase by $80,000, the new net operating income will be $50,300.
3. If the selling price is reduced by 10% and the advertising budget is increased by $60,000, the new net operating income will be a loss of $43,500.

Step-by-step explanation:

1. CM Ratio:

The CM ratio can be calculated by dividing the contribution margin by the sales:

CM Ratio = Contribution Margin / Sales

CM Ratio = $175,500 / $585,000

CM Ratio = 0.3 or 30%

Break-even Point in Unit Sales:

The break-even point in unit sales can be calculated by dividing the fixed expenses by the contribution margin per unit:

Break-even Point in Units = Fixed Expenses / Contribution Margin per Unit

Break-even Point in Units = $180,000 / ($30 - $20)

Break-even Point in Units = 18,000 units

Break-even Point in Dollar Sales:

The break-even point in dollar sales can be calculated by multiplying the break-even point in unit sales by the selling price per unit:

Break-even Point in Dollar Sales = Break-even Point in Units * Selling Price per Unit

Break-even Point in Dollar Sales = 18,000 units * $30

Break-even Point in Dollar Sales = $540,000

2. If the monthly sales increase by $80,000 due to the increased advertising budget and sales effort, the new net operating income can be determined using the incremental approach:

New Net Operating Income = Net Operating Loss + Increase in Sales - Increase in Variable Expenses

New Net Operating Income = ($4,500) + $80,000 - ($16,000 * 0.7)

New Net Operating Income = $50,300

3. If the company reduces the selling price by 10% and increases the advertising budget by $60,000, the new contribution format income statement will look as follows:

Sales (19,500 units × $30 per unit * 0.9) $526,500

Variable expenses (19,500 units × $20 per unit) 390,000

Contribution margin $136,500

Fixed expenses 180,000

Net operating income $ (43,500)

4. To earn a profit of $9,750, the number of units to be sold each month can be calculated as:

Profit = (Unit CM * Units sold) - Fixed Expenses

$9,750 = ($30 - $20) * Units sold - $180,000

Units sold = ($9,750 + $180,000) / ($30 - $20)

Units sold = 19,000 units

5. a. If the company automates its operations, the new CM ratio and the new break-even point in both unit sales and dollar sales can be calculated as:

New CM Ratio = (Contribution Margin - Variable Expenses per Unit) / Sales

New CM Ratio = ($175,500 - $17,500) / $585,000

New CM Ratio = 0.28 or 28%

New Break-even Point in Units = Fixed Expenses / (Unit CM - Variable Expenses per Unit)

New Break-even Point in Units = $180,000 / ($30 - $17.5 - $3)

New Break-even Point in Units = 12,000 units

New Break-even Point in Dollar Sales = New Break-even Point in Units * Selling Price per Unit

New Break-even Point in Dollar Sales = 12,000 units * $30

New Break-even Point in Dollar Sales = $360,000

b. Assuming the company expects to sell 26,000 units next month:

If operations are not automated:

Sales (26,000 units × $30 per unit) $780,000

Variable expenses (26,000 units × $20 per unit) 520,000

Contribution margin $260,000

Fixed expenses 180,000

Net operating income $80,000

If operations are automated:

Sales (26,000 units × $30 per unit) $780,000

Variable expenses (26,000 units × ($20 - $3) per unit) 494,000

Contribution margin $286,000

Fixed expenses 252,000

Net operating income $34,000

c. Whether the company should automate its operations depends on a number of factors, such as the additional fixed expenses, the potential increase in sales, and the expected increase in net operating income. Considering the increase in net operating income is relatively small and the potential increase in sales, the company may want to carefully assess the cost and benefits before making a decision to automate its operations.