Question

NewYork Auto has been in the tire business for four years. It rents a building and owns all of its equipment. All employees are paid a fixed salary except for the busy season (April-June), when temporary help is hired by the hour. Utilities and other operating charges remain fairly constant during each month except those in the busy season.

Selling prices per tire average $75 except during the busy season.Because a large number of customers buy tires prior to winter, discounts run above average during the busy season. A 15% discount is given when two tires are purchased at the same time. During the busy months, selling prices per tire average $60.

The firm's owner (Mr. John) is disappointed with the reports and cost computations prepared by the firm's accountant because the cost behavior patterns displayed by the monthly breakeven charts are inconsistent; the busy months' charts are different from the other months of the year. He is never sure if the company has a satisfactory margin of safety or if it is just above the breakeven point.

(a) What is wrong with computation made by the firm’s accountant?

(b) how can the information above be presented in a better format for Mr. John?

Answer 1

(a) The firm's accountant has presented a different break even for each season since the selling prices are varying. However, break even point must be the same throughout the year irrespective of the selling price since the fixed costs will remain whatever the season may be. They must sell a certain number of units to recover the fixed costs without having consideration to the varying selling price or contribution. A varying break even point will lead to incorrect buying decisions and raise all other costs above budget for the business.

(b) The information can be presented in a better manner by using weighted average contribution technique to estimate the break even point. In a weighted average contribution margin, the contribution for each of the months is taken as an average and then divided by the fixed cost. This is will give the owner a better idea of how many units must the firm sell to break even at all times, the margin of safety planning and the actual profitability of the firm.