Question

College Enterprises is a large importer of the highest quality Asian rugs, carpets, and similar products. The company is divided into 18 segments based on the country of origin of the rugs. The manager for the Indian Rug Group believes that demand for these special rugs is highly flexible, tied closely to the domestic economy and the performance of the U.S. dollar in world markets. However, some customers will purchase the rugs no matter what the price or state of the economy. Indian rugs are sold by the square metre, currently averaging R50 per square metre. In the financial year ending January 31, 2016, the company sold 1 million square metres of rugs in the Indian Rug Group. The group manager has just received the following statement for the year (in millions): Sales R 50 Variable costs R 30 Contribution margin R 20 Fixed costs R 15 Income before tax R 5 College has R10 million invested in the Indian Rug Group and thus the R5 million in income before tax represents a 50 percent before-tax rate of return on investment. This is a very good rate of return; however, no one in the company knows how the the Indian Rug Group would fare if there were a supply shortage or a downturn in the economy.

Required

a Compute the break-even volume in units and in rands for the Indian Rug Group for the fiscal year ending January 31, 2016 2

b Calculate the margin of safety and the operating leverage ratios for the past fiscal year.

3 c If sales volume were 10 percent lower last year, what would be the impact on net income? 3

d A marketing consultant estimates that sales of the Indian Rug Group could drop to 800 000 square metres this year. (i) Compute the operating leverage ratio for 800 000 square metres. 5 (ii) Why does the operating leverage ratio for this part differ from part B 2

Answer 1

A)
CONTRIBUTION PER UNIT	$                                                                                                                                  20
FIXED COST	$                                                                                                                 15,000,000
BREAK EVEN UNITS	FIXED COST
	CONTRIBUTION PER UNIT
	$                                                                                                                 15,000,000
	$                                                                                                                                  20
BREAK EVEN UNITS	750000	UNITS
B)
MARGIN OF SAFETY	CURRENT SALES - BREAK EVEN SALES	* 100
	CURRENT SALES
	1000000 - 750000	* 100
	1000000
	25	%
OPERATING LEVERAGE	[Quantity x (Price – Variable Cost per Unit)]
	Quantity x (Price – Variable Cost per Unit) – Fixed Operating Costs
	1000000 * (50 - 30)
	1000000 * (50 - 30) -15000000
	20000000
	5000000
	4
C)
REDUCTION IN SALES VOLUME	100000	UNITS
CONTRIBUTION PER UNIT	$                                                                                                                                  20
REDUCTION IN INCOME	$                                                                                                                    2,000,000
D)
i)
OPERATING LEVERAGE	[Quantity x (Price – Variable Cost per Unit)]
	Quantity x (Price – Variable Cost per Unit) – Fixed Operating Costs
	800000 * (50 - 30)
	800000 * (50 - 30) -15000000
	16000000
	1000000
	16
ii)
The fixed costs remains the same and the units sold reduced, therefore the profit reduced.
A high degree of operating leverage provides an indication that the company has a high proportion of fixed operating costs compared to its variable operating costs.