Cost and Decision-Making Analysis

m3a2_ra1_solution.xlsx

Home >Business & Finance homework help >Accounting homework help >Cost and Decision-Making Analysis

RA1 Solution

Required Assignment 1 - Excel Solution
Expected response:
1. The overall break-even sales can be determined using the CM ratio.
	Velcro	Metal	Nylon	Total
Sales	$165,000	$300,000	$340,000	$805,000
Variable expenses	125,000	140,000	100,000	365,000
Contribution margin	$40,000	$160,000	$240,000	$440,000
Fixed expenses				400,000
Net operating income				$40,000
	CM ratio =	Contribution margin		= $440,000	= 0.5466
		Sales		$805,000
	Dollar sales to break-even =		Fixed expenses = $400,000 = $732,000 (rounded)
			CM ratio	0.5466
2. The issue is what to do with the common fixed cost when computing the break=evens for the individual
products. The correct approach is to ignore the common fixed costs. If the common fixed costs are included
in the computations, the break-even points will be overstated for individual products and managers may
drop products that are in fact profitable.
	a. The break=even points for each product can be computed using the contribution margin approach as follows:
		Velcro	Metal	Nylon
Unit selling price		$ 1.65	$ 1.50	$ 0.85
Variable cost per unit		1.25	0.70	0.25
Unit contribution margin (a)		$ 0.40	$ 0.80	$ 0.60
Product fixed expense (b)		$ 20,000	$ 80,000	$ 60,000
Unit sales to break-even (b) ÷ (a)		50,000	100,000	100,000
	b. If the company were to sell exactly the break-even quantities computed above, the company would lose
	$240,000--the amount of the common fixed cost. This can be verified as follows:
		Velcro	Metal	Nylon	Total
Unit Sales		50,000	100,000	100,000
Sales		$ 82,500	$ 150,000	$ 85,000	$ 317,500
Variable expenses		62,500	70,000	25,000	157,500
Contribution margin		$ 20,000	$ 80,000	$ 60,000	160,000
Fixed expenses					400,000
Net operating income					($ 240,000)
	At this point,you may conclude that something is wrong with the answer to part (a) because a result
	in which the company loses money operating at the break-evens for the individual products does not seem to
	make sense. You may also be concerned that managers might be lulled into a false sense of security if they
	are given the break-evens computed in part (a). A total sale at the individual product break-evens is only
	$317,500 whereas the total sales at the overall break-even computed in part (1) is $732,000.
	You may attempt to resolve this apparent paradox by allocating the
	common fixed costs among the products prior to computing the break-evens for individual products. Any of a
	number of allocation bases could be used for this purpose--sales, variable expenses, product-specific fixed expenses,
	contribution margins, etc. For example, the common fixed costs are allocated on the next section based on sales.
Allocation of common fixed expenses on the bases of sales revenue:
		Velcro	Metal	Nylon	Total
Sales		$165,000	$300,000	$340,000	$805,000
Percentage of total sales		20.497%	37.267%	42.236%	100.000%
Allocated common fixed expense*		$ 49,193	$ 89,441	$ 101,366	$ 240,000
Product fixed expenses		20,000	80,000	60,000	160,000
Allocated common and product fixed
expenses (a)		$ 69,193	$ 169,441	$ 161,366	400,000
Unit contribution margin (b)		$ 0.40	$ 0.80	$ 0.60
"Break-even point in units sold (a) ÷ (b)		172,981	211,801	268,944
*Total common fixed expenses X percentage of total sales
If the company sells 172,983 units of the Velcro product, 211,801 units of the Metal product, and 268,943 untis of
the Nylon product, the company will indeed break-even overall. However, the apparent break-evens for two
of the products are higher than their normal annual sales.
	Velcro	Metal	Nylon
Normal annual sales	100,000	200,000	400,000
"Break-even" annual sales	172,981	211,801	268,944
"Strategic" decision	drop	drop	retain
It would be natural to interpret a break-even for a product as the level of sales below which the
company would be financially better off dropping the product. Therefore, based on the above
erroneous break-even calculation, the decision to drop the Velcro and Metal products and concentrate on the
company's core competency, which appears to be the Nylon product, may be made.
If the Velcro and Metal products are dropped, the company would face a loss of $60,000 computed as follows:
	Velcro	Metal	Nylon	Total
Sales	dropped	dropped	$340,000	$340,000
Variable expenses			100,000	100,000
Contribution margin			$240,000	$240,000
Fixed expenses				300,000
Net operating income				($ 60,000)
By dropping the two products, the company reduces its fixed expenses by only $100,000 (=$20,000 + $80,000).
Therefore, the total fixed expenses are $300,000 rather than $400,000.
By dropping the two products, the company would go from making a profit of $40,000 to suffering a loss of
$60,000. The reason is that the two dropped products were contributing $100,000 toward covering common
fixed expenses and toward profits. This can be verified by looking at a segmented income statement like the one
that will be introduced in a later module.
	Velcro	Metal	Nylon	Total
Sales	$165,000	$300,000	$340,000	$805,000
Variable expenses	125,000	140,000	100,000	365,000
Contribution margin	$40,000	$160,000	$240,000	440,000
Product fixed expenses	$ 20,000	$ 80,000	$ 60,000	160,000
Product segment margin	$20,000	$80,000	$180,000	280,000
Common fixed expenses				$ 240,000
Net operating income				$ 40,000
	$100,000

Notes: This assignment looks at ability to calculate the break-even point and demonstrate the ability to apply the concept to make managerial decisions. Be sure to provide analysis and applications of the numbers, and how management within the case will use these numbers to make mangerial decisions. Applications of the concepts is the most important objective of the overall course.