Question

Gary G's is a small company that currently operates in Knoxville, TN and has a single product - stadium seat cushions bearing the University of Tennessee logo. Eventually Gary wants to expand and sell this product for other university and professional sports teams, and to add other merchandise. In the meantime, Gary is having a little difficulty understanding margins, and operating income and product mix. "I'll never understand this accounting stuff," Gary yelled, waving the income statement he had just received from his accountant in the morning mail. "last month we sold 1,000 stadium seat cushions and earned $6,850 in operating income. This month, when we sold 1,500. I thought we'd make $10,275. But this income statement shows an operating income of $12,100! How can I ever make plans if I can't predict my income? I'm going to give Cathy one last chance to explain this to me," he declared as he picked up the phone to call Cathy, his accountant "Will you try to explain this operating income thing to me one more time please?" Gary asked Cathy. "After I saw last month's income statement, I though each cushion we sold generated $6.85 in net income; now this month, each one generates $8.07! There was no change in the price we paid for each cushion, and we didn't change our selling price, so I don't understand how this happened. If I had known I was going to have $12,100 in operating income, I would have looked more seriously at adding to our product line." Taking a deep breath, Cathy replied, "Sure, Gary. I'd be happy to explain how you made so much more operating income than you were expecting." Required: 1. Assume the role of Cathy. Explain to Gary why his use of operating income per cushion was in error. 2. Using the following income statements, prepare a contribution margin income statement for October September October Sales $25,000 $37.500 Cost of Goods Sold 6.000 15.000 Gross Profit 15.000 22 500 Rent Expense 1.500 1.500 Wages Expenses 3.500 .000 Shipping expense 1.250 1.875 Utilities expense 750 750 Advertising expense 750 875 Insurance expense 400 400 Operating income S6850 S12100 Wages and advertising are mixed costs. The fixed portion of each of those costs is $500.

Answer 1

You have just asked so many questions in the same post. I have addressed first four of them. Please post the balance question separately.

Part (1)

Operating income per cushion as calculated by Gary is erroneous because he has simply prorated all the revenues and costs with respect to volume to obtain the figure for this month. Last month, operating income was 6,850 when sales were 1,000 units. This month sales were 1,500 i.e. 50% increase. He expected the same 50% increase in operating income resulting into a figure of 6,850 x (1 + 50%) = 10,275. He then divided the operating income by volume to obtain operating income per cushion as 6,850 / 1,000 = 6.85 = 10,275 / 1,500. While doing so he has knowingly or unknowingly ignored the actual behavior of costs. He has unknowingly assumed that all costs will rise in proportion to sales volume. In a way, he has assumed all the costs to be variable, which is not true. That's why his calculation is erroneous.

Part (2)

Contribution margin income statement for the month of October:

Parameter	Linkage	$
Sales	A	37,500
Variable costs
Cost of Goods Sold	B	15,000
Variable wages expense	C = 5000 - 500	4,500
Shipping expense	D	1,875
Variable Advertising expense	E = 875 - 500	375
Total Variable Costs	F = B + C + D + E	21,750
Contribution Margin	G = A - F	15,750
Fixed costs
Rent expense	H	1,500
Fixed wage expenses	I	500
Fixed advertising expense	J	500
Utilities expense	K	750
Insurance expense	L	400
Total Fixed expenses	M = H + I + J + K + L	3,650
Operating income	N = G - M	12,100

Part (6)

Based on the table above, contribution margin per unit = CM = 15,750 / 1,500 = 10.50

First option: Operating income = CM x Volume - Fixed cost - incremental advertisement cost = 10.50 x 960 - 3,650 - 1,200 =  5,230

Second option: Variable cost per unit = VC = 21,750 / 1,500 = 14.50

Original sale price = 37,500 / 1,500 = 25

New sale price = 25 x (1 - 10%) = 22.50

New CM = 22.50 - 14.50 = 8.00

Operating income = 8.00 x 1,000 - 3,650 = 4,350

Since operating income is higher in case of first option, Gary should implement First option.

Let Q be the level of sales to remain indifferent between the two option. Operating income then should remain same in both the cases.

Hence, 10.50 x Q - 3,650 - 1,200 = 8 x Q - 3,650

Hence, 2.50Q = 1,200

Hence, Q = level of sales for indifference between the two options = 1,200 / 2.5 = 480

Part (7)

Income level for 1,200 cushions = 10.50 x 1,200 - 3,650 = 8,950

Cushion cost price per unit = 15,000 / 1,500 = 10

Incremental cost price = 20% = 20% x 10 = 2

Incremental cost = 2 x 1,200 = 2,400

Revised profit = 8,950 - 2,400 = 6,550

if price is increased by 50% x increase in cost price = 50% x 2 = 1

New contribution margin = 10.50 - 2 + 1 = 9.50

New volume = 1,200 x (1 - 5%) = 1,140

New profit = 9.50 x 1,140 - 3,650 = 7,180 > 6,550

Hence, Gary should increase the price.