Question

Chapter 6 - practice problem USA Security Systems is a company that installs a standard home security system for residential customers. Each system is sold for $3,500. The cost to put together and install the system is $1,925, In addition, the sales staff receives a commission of 10% of the selling price. Fixed costs are expected to be $551,250 and the company plans to sell 720 units. 1. Prepare a contribution format income statement 2. Compute the contribution margin ratio. 3. Determine the breakeven point in both units and sales dollars. 4. Compute the margin of safety in dollars and as a percentage. 5. Compute operating leverage. If sales are expected to increase by 10%, how much will the new net income be?

Answer 1

In the present case the sale price per unit is $3,500. Variable cost comprises of material & installation cost of $1,925 per unit and 10% sales commission to sales staff. Fixed cost is $551,250. Expected units to be sold are 720 units.

Answers are as following:

1. Contribution format Income Statement

Income Statement is prepared for the period. Since no period is mentioned in question, period to be mentioned in heading is left blank

USA Security Systems
Income Statement for the year ended on _______
Revenue	$	$
Sales		2,520,000
Less: Variable Cost
Material & Installation	1,386,000
Sales commission to sales staff	252,000	1,638,000
Contribution Margin		882,000
Less: Fixed Cost
Fixed Expenses		551,250
Net Operating Income		330,750

Explanation:

Sales value= Sale price per unit * No. of units

=3500*720

=$2,520,000

Material & Installation cost = No. of units * Material & installation cost per unit

=720*1925 =$1,386,000

Sales commission to sales staff= Sales value * 10%

= 2,520,000 * 10%

= $252,000

2. Contribution Margin Ratio:

To calculate Contribution Margin Ratio, formula is :

Contribution Margin Ratio = Contribution Margin + Sales Revenue

Here we have calculated contribution margin in Answer 1 above, which is Sales less Variable cost i.e. $882,000

Therefore, for present case

Contribution Margin Ratio = 882,000 - 2,520,000 = 0.35

3. Break even point:

Break Evenpoint inunits) = FixedCost = (SP - VC)

SP= Selling Price per unit

VC = Variable cost per unit

here in present case,

Break Evenpoint inunits) = 551, 250 = (3500 - 2275)

=450 units

Sale price per unit = $3,500

Total Variable cost is $ 1,638,000 as calculated in Answer 1

Variablecostper unit = 1,638,000 = 720 = 2,275

formula to calculate break even point (in sales $) is as under

Fixedcost = Contribution Margin Ratio

551, 250 -0.35

=$1,575,000

Contribution Margin Ratio is explained in Answer 2

4. Margin of safety

Margin of Safety in $ = Current Estimated Sales - Break even Sales

= 2,520,000 - 1,575,000

= $945,000

Current estimated sale is the sale which is estimated for the period i.e 720 units * $3,500

Break even sales is $1,575,000 as calculated in Answer 3

Margin of Safety % = (Margin of Safety in $ divided by Current estimated Sales) * 100

= ($945,000 / $2,520,000) *100

= 35.50%

5. Operation leverage

Formula to calculate operating leverage = Contribution Margin divided by Net operating income

= 882,000 / 330,750

= 2.67

Contribution Margin & Net operating income are calculated in Answer 1 above.

If sales increase by 10% i.e 720 units + 10% = 792 units. Income statement will be made as shown below. All the formula and steps will be as per Answer 1. Only difference will be instead of 720 units, 792 units will be considered. There will be no change in fixed cost.

New Net income will be $418,950

USA Security Systems
Income Statement for the year ended on _______
Revenue	$	$
Sales		2,772,000
Less: Variable Cost
Material & Installation	1,524,600
Sales commission to sales staff	277,200	1,801,800
Contribution Margin		970,200
Less: Fixed Cost
Fixed Expenses		551,250
Net Operating Income		418,950

Explanation:

Sales value= Sale price per unit * No. of units

=3500*792

=$2,772,000

Material & Installation cost = No. of units * Material & installation cost per unit

=792*1925 =$1,524,600

Sales commission to sales staff= Sales value * 10%

= 2,772,000 * 10%

= $277,200