Question

Judy Billows, owner of Billows Manufacturing has called a meeting with her department heads. She presents last year's contribution margin income statement (see below), which is based on a sales volume of 100,000 units (one product offering) and operating income of $125,000. She issues a challenge to her vice presidents to increase operating income in the next year by 20% to $150,000. The VP of Marketing states that if the sales price were reduced by 10% to $22.50 per unit, the sales volume could increase to 125,000 units, thereby increasing Revenue by 12.5% to $2,812,500, generating an additional $312,500 to meet the challenge. Unsure about this statement, Judy asks for options from the VP of Manufacturing, who responds that if they were allowed to purchase a new piece of equipment for $500,000 with a 10 year useful life, while annual fixed costs would increase by $50,000 a year, the resulting automation would result in a $0.61 per unit (about 5%) decrease in total variable costs.

Prior year Contribution Margin statement:

Sales Revenue $25 per unit $2,500,000

Variable Costs $12.25 per unit 1,225,000

Contribution Margin $12.75 per unit 1,275,000

Fixed Costs   1,150,000

Operating Income $125,000

1) With your knowledge of variable and fixed cost behavior and cost-volume-profit analysis, please respectfully explain to Judy and the VP of Marketing why the 10% reduction in the sales price resulting in an increase in volume to 125,000 units will not, by itself, result in an increase in operating income of $312,500.

2) Provide a brief summarized memo to discuss if both the decrease in the sales price (resulting in an increase in volume) and the purchase of new equipment for automating the manufacturing process will support the increase in operating income to the desired $150,000 level. Consider how the risk of the organization changes with a change in the cost structure, what happens if the expected volume is not achieved? Support your comments with a financial analysis.

3) In your thread response to your colleagues, make suggestions for improving their analysis or explanation (for instance can you point out any additional risks or nonfinancial factors that should be considered).

Answer 1

a Income Statement Prior year C100,000 units) de costpu particulars Total ( Sales Revenue variable costs contribution $25 $ 12.25 $12.79 2500, DOO 1,225,000 , 295, ODO (1,150000) 125,000 w fined COSES Income 16) Income 10% Statement if sales Price Reduced by increase in volume to 125,000 hits Total cost pou particutars Sales Revenue 22.5 2812.500 (12.25) 1,531,250 (- variable costs 10.25 1,281,250 - (1, 150,000) (a) Fined costs 131,250 Answer to part I in Question: - - from above (b) of Sales Price Reduction by 10% will not achieve Target Profit the reason as follows (i decrease in contribution margin ranber contribution margin = $12.75pu NOW = $ 16.25 pu

( Increase in volume is not enough. Operting profit v = $131,250 Target profit = $ 150,000 Additional profit Required = 18,750 Addition Sales - Addition profit contributionpu 18,750 10.25 If sales were target profit - 1830 mits Cromded off) - 125000+ 1830 = 126,830 will be achieved. (C) Income statement if we combine Both options, Reduction in selling price, posle purchase new equipment particulars Amont (2) $22.5 Amont (2) 2,812,500 1,455,000 Sales Revenue (W variable costs ($12-25-0.61) $11.64 $11.64 (1) H Fined costs Additional fined costs 1,357,500 1,150,000 50,000 50,000 o on (4) Dereciation on New (500,000/10) Equipment $ 109,500
ans 1) increase in sales and reduction is selling price will not achieve targetd

Ans2) reduction in sales price and purchase new equipment will not achieve target profit

Answer to part 3

Company shall try to new techniques in reduction of variable costs, increase in sales volume with out reduction in sales price