Question

Data for Hermann Corporation are shown below:

Per unit Percent
of Sales
Selling price $90 100%
Variable expenses
63

70%

Contribution margin
$27

30%

Fixed expenses are $30,000 per month and the company is selling 2,000 units per month.

Requirement 1:
(a)Calculate the increase or decrease in net operating income if a $5,000 increase in the monthly advertising budget would increase monthly sales by $9,000. net operating income: ?
(b)Should the advertising budget be increased as suggested in requirement 1(a) above?
Requirement 2:
Refer to the original data. Management is considering using higher-quality components that would increase the variable cost by $2 per unit. The marketing manager believes the higher-quality product would increase sales by 10% per month. Should the higher-quality components be used?

Answer 1

Requirement (a)

The cost benefit analysis will be suitable here for short term decision making.

Cost Benefit Net

Increase in Fixed Cost (W-1) ($5000) ($5000)

Increase in Total Contribution (W-2) $2700 $2700

Net Decrease in Operating Income ($5000) $2700 ($2300)

Working 1 The net increase in the fixed cost is $5000 which is given in the requirement (a).

Working 2 Net increase in Total contribution by increasing the monthly advertising expense by $5000 is:

30% * $9000 = $2700

Requirement (b)

As the net difference is a decrease in operating income by $2300 so it is not a suitable option for the company.

Requirement 2

Again here we will appraise the suitability of the option by using cost benefit analysis.

Cost Benefit Net

Increase in T.Variable Cost (W-3) ($4400) ($4400)

Increase in Total Contribution (W-4) $1000 $1000

Net Decrease in Operating Income ($4400) $1000 ($3400)

Decision: As the net difference is $3400 negative so it is better that we don't opt to increase the component cost by $2.

Working 3 The net increase in the Total Variable cost is:

Increase in Total Variable cost = $2 net increase in variable cost per unit * total units after opting to higher quality components

Increase in Total Variable cost = $2 * (2000*110%) = $4400

Working 4 Net decrease in contribution per unit is $2 as a result of increasing the Variable cost per unit by $2.

Due to the increase in the total number of units sold the total contribution will increase if the difference of contribution on increased units and contribution on older number of units is positive.

Total Contribution after taking the decision to increase variable cost by $2 is:

Total contribution = 2000 * 110% * $(27-2) = $55000

Total Contribution before taking the decision to increase variable cost by $2 is:

Total contribution = 2000 * $27 = $54000

So the Net difference is $1000 positive (55000-54000).