Question

Having the ability to effectively communicate is one of the most important skills a business executive can possess. As French businesswoman and author Mirelle Guilliano has said, "Intelligence, knowledge or experience are important and might get you a job, but strong communication skills are what will get you promoted." My own business experience supports this statement. By the time individuals have a few years of experience, they have great technical skills and can assemble, analyze, and categorize data to make solid business decisions. In the end, however, they are often unable to communicate the results of their analysis effectively. When I speak to senior executives and inquire about educational needs, the conversation invariably turns to communications. In accounting, by necessity, we focus on financial and quantitative data, but it is important to remember that as accountants we must be able to present the results of our analysis or studies to management. Through effective communications, accountants can truly impact business decisions and make their careers soar. The best way to get better at anything is to practice. That’s the basis for this assignment – to practice written communication.

Grayslake Novelty produces and sells a small novelty item through tourist shops in Chicago and other northern Illinois locations. Last year the company sold 198,400 units. The income statement for Grayslake Novelty for last year is shown below:


Sales $992,000
Less: Variable Expenses 545,600
Contribution Margin 446,400
Less: Fixed Costs 180,000
Net Operating Income $266,400

While the company has been profitable, as shown in the above income statement, sales began falling near the end of last year and have continued to decline this year. There is concern that new competitors are beginning to take market share from Grayslake Novelty. As a result, Sarah Burroughs, the company president, has asked you to provide some information to assist her in making decisions about the company’s strategy for this product. These alternatives should be evaluated individually as stated. You are free to offer your own alternative based on any of the parameters given in the data.

Required:

a. While the company is currently profitable, the president wants to know the contribution margin and the breakeven in both units and dollars using last year’s level of sales. Additionally, compute the margin of safety, margin of safety
ratio, and degree of operating leverage based on last year’s sales.

b. One of the possible strategies (Alt 1) is to reduce the current price by 8%. Using last year’s level of sales, what is the new contribution margin and break-even in units and dollars based on the price reduction? Additionally, compute
the margin of safety, margin of safety ratio, and degree of operating leverage based on last year’s sales.

c. A second strategy (Alt 2) is to reduce the current variable cost by 0.20 per unit. The company has identified available efficiencies that can be implemented without any additional changes to the current cost. What is the new
contribution margin and break-even in units and dollars based on the variable cost reduction of 0.20 per unit? Additionally, compute the margin of safety, margin of safety ratio, and degree of operating leverage based on last year’s
sales.

d. A third strategy (Alt3) is to decrease the current price by 8% and reduce the variable cost per unit by 0.20. What is the new contribution margin and break-even in units and dollars based on making both changes? Additionally,
compute the margin of safety, margin of safety ratio, and degree of operating leverage based on last year’s sales.

Answer 1

Grayslake Novelty

Effective Communication by a business executive:

a. Using last year's level of sales:

a1. Contribution Margin:

= Selling price minus variable cost

= $5.00 - $2.75 = $2.25

a2. Breakeven in units:

= Fixed Costs/Contribution margin

= $180,000/$2.25 = 80,000 units

a3. Breakeven in dollars:

= Fixed Cost/Contribution margin ratio

= $180,000/45% = $400,000

a4. Margin of Safety:

= Current Sales - Break-even Point (in dollars)

= $992,000 - $400,000

= $592,000

a5. Margin of Safety Ratio:

= (Current Sales - Break-even Point (in dollars))/Sales x 100

= ($992,000 - 400,000)/$992,000 x 100

= 59.68% or 60%

a6. Degree of operating leverage:

= (Sales minus Variable)/(Sales minus Variable and Fixed Costs)

= ($992,000 - $545,600)/($992,000 - $545,600 - $180,000)

= $446,400/266,400 = 1.68

OR

= Contribution /Net Operating Income

= $446,400/$266,400 = 1.68

b: Alternative 1: Reduction of the current price by 8%:

b1.Contribution Margin:

= Selling price minus variable cost

= $4.60 - $2.75 = $1.85

b2. Breakeven in units:

= Fixed Costs/Contribution margin

= $180,000/$1.85 = 97,297 units

b3. Breakeven in dollars:

= Fixed Cost/Contribution margin ratio

= $180,000/40%

= $450,000

b4. Margin of Safety:

= (Current Sales - Break-even Point (in dollars)

= $912,640 - $450,000 = $462,640

b5. Margin of Safety Ratio:

= (Current Sales - Break-even Point (in dollars))/Sales x 100

= $912,640 - $450,000)/$912,640 x 100

= 51%

b6. Degree of operating leverage:

= Contribution /Net Operating Income

= $367,040/187,040 = 1.96

c: Alternative 2: Reduction of current variable cost by $0.20 per unit:

c1.Contribution Margin:

Selling price - variable cost

= $5.00 - $2.55 = $2.45

c2. Breakeven in units:

=Fixed cost/Contribution margin per unit

= $180,000/$2.45 = 73,469 units

c3. Breakeven in dollars:

=Fixed cost/Contribution margin ratio

= $180,000/49% = $367,347

c4. Margin of Safety:

= (Current Sales - Break-even Point (in dollars)

= $992,000 - $367,347

= $624,653

c5. Margin of Safety Ratio:

= (Current Sales - Break-even Point (in dollars))/Sales x 100

= $624,653/$992,000 x 100

= 63%

c6. Degree of operating leverage:

= Contribution /Net Operating Income

= $486,080/$306,080

= 1.59

d: Alternative 3: Reduction of Current price by 8% and Variable Cost by $0.20 per unit:

d1.Contribution Margin:

= Selling price - variable cost

= $4.60 - $2.55 = $2.05

d2. Breakeven in units:

= Fixed cost/Contribution margin per unit

= $180,000/$2.05

= 87,805 units

d3. Breakeven in dollars:

= Fixed cost/Contribution margin ratio

= $180,000/45%

= $400,000

d4. Margin of Safety:

= (Current Sales - Break-even Point (in dollars)

= $912,640 - $400,000

= $512,640

d5. Margin of Safety Ratio:

= (Current Sales - Break-even Point (in dollars))/Sales x 100

= $512,640/$912,640 x 100 = 56.2%

d6. Degree of operating leverage:

= Contribution /Net Operating Income

= $406,720/$226,720

= 1.8

Step-by-step explanation:

1) Data and Calculations:

Last Year Alt 1 Alt 2 Alt 3

Sales $992,000 $912,640 $992,000 $912,640

Less: Variable Expenses 545,600 545,600 505,920 505,920

Contribution Margin 446,400 367,040 486,080 406,720

Less: Fixed Costs 180,000 180,000 180,000 180,000

Net Operating Income $266,400 $187,040 $306,080 $226,720

Unit selling price = Sales/Quantity sold = $992,000/198,400 = $5.00

Alternative 1, selling price = $5.00 x 92% = $4.40

Sales = $4.60 x 198,400 = $912,640

Last year's

Contribution Margin ratio = Contribution Margin/Sales Value = 45%

Contribution per unit = Selling price x Contribution margin ratio

= $5 x 45% = $2.25

Variable cost per unit = Selling price - Contribution per unit

= $5 - $2.25 = $2.75 or 55% of selling price.

Alt 1:

Contribution margin ratio = Contribution margin/Sales = 40.22%

Contribution per unit = $4.60 x 40.22% = $1.85

Variable cost = Selling price - Contribution per unit = $4.60 - $1.85 = $2.75

Alt 2:

Variable cost = $2.75 - $0.20 = $2.55

Contribution per unit = $5 - $2.55 = $2.45

Contribution margin ratio = $2.45/$5 x 100 = 49%

Alt 3: Alternative 3: Reduction of Current price by 8% and Variable Cost by $0.20 per unit:

Sales = 198,400 x $4.60 = $912,640

Variable Cost per unit = $2.75 - $0.20 = $2.55

Total Variable cost = 198,400 x $2.55 = $505,920

Contribution margin per unit = $4.60 - $2.55 = $2.05

Contribution margin ratio = $2.05/$4.60 x 100 = 45%

The above ratios on the financial performances of Grayslake Novelty under different scenarios communicate some information to the president about the outcome of each alternative. From the analysis, it is easier for management to make a choice of the strategy to pursue in order to achieve its objectives.

Note that the operating leverage measures how the operating income responds to changes in sales for Grayslake Novelty given the alternatives.