Question

Problem 11-29 Margin of safety and operating leverage LO 11-6 Hampton Company is considering the addition of a new product to its cosmetics line. The company has three distinctly different options: a skin cream, a bath oil, or a hair coloring gel. Relevant information and budgeted annual income statements for each of the products follow Relevant Information Skin Cream Bath Oil Color Gel 118.000 198,000 78,000 Budgeted sales in unite (a) Expected sales price (b) Variable conta per unit (c) Income statements Sales revenue (axb) Variable conte ( a e ) Contribution margin Fixed costs Net Income $1.062.000 (236,000) 826,000 (504,000) $ 322,000 $ 990,000 (594,000) 396,000 (280,000) $ 116,000 $936,000 624,000) 312,000 (92,000) $ 220,000 Required: a. Determine the margin of safety as a percentage for each product. b. Prepare revised Income statements for each product, assuming a 20 percent increase in the budgeted sales volume. c. For each product, determine the percentage change in net income that results from the 20 percent increase in sales d. Assuming that management is pessimistic and risk averse, which product should the company add to its cosmetics line? e. Assuming that management is optimistic and risk aggressive, which product should the company add to its cosmetics line?

Answer 1

Please find below table useful to compute desired results: -

A BC Skin Cream Bath Oil 118000 198000 Color Gel 78000 2 Budgeted Sales in Units 3 Expected Sales price 4 Variable costs per unit 5 Income Statements 6 Sales revenue 7 Variable costs 8 Contribution Margin 9 Fixed Costs 10 Net Income 11 12 Increase in Sales Particulars Sales Revenue Less: Variable costs Contribution Margin Less: Fixed Costs Net Income Hampton Company Income Statement Skin Cream Bath Oil Color Gel =B6+B12*B6 =C6+C6*B12 =D6+D6*B12 =B7+B7*B12 =C7+C7*B12 =D7+D7*B12 =G4+G5 =H4+H5 =14+15 =B9 =C9 =D9 =G6+G7 =H6+H7 =I6+17 =B2 B3 =-B2*B4 =B6+B7 =-504000 =B8+B9 =C2*C3 =D2 D3 =-C2*C4 =-D2 D4 =C6+C7 =D6+D7 -280000 -92000 =C8+C9 =D8+D9 =20/100 =H8 Calculation of age change in Net Income Particulars Skin Cream Bath Oil Net Income after increase in sales 1=G8 Less: Net Income as before I=B10 =C10 Increase in Net Income =G12-G13 =H12-H13 Sage change in Net Income =G14/G13 =H14/H13 13 Color Gel =I8 =D10 =112-113 =114/113 =B6 14 Calculation of Margin of safety as a age 15 Particulars Skin Cream Bath Oil Color Gel 16 Contribution Margin =B8 =C8 =D8 17 Sales Revenue =C6 =D6 18 Contribution margin Ratio =B16/B17 =C16/C17 =D16/D17 19 Net Income =B10 =C10 =D10 20 Margin of Safety =B19/B18 =C19/C18 =D19/D18 21 Margin of safety as a %age =B20/B17 =C20/C17 =D20/D17 Particulars Contribution Margin Net Income Operating Leverage Computation of Operating Leverege Skin Cream Bath Oil =B8 =C8 =B10 =C10 =G19/G20 =H19/H20 Color Gel =D8 =D10 =119/120

End results would be as follows: -

с B G H I 1 Skin Cream Bath Oil Color Gel Hampton Company 2 Budgeted Sales in Units 118.000 198,000 78,000 Income Statement 3 Expected Sales price 12 Particulars Skin Cream Bath Oil Color Gel 4 Variable costs per unit 8 | Sales Revenue 1.274.400 1.188.000 1.123,200 5 Income Statements Less: Variable costs (283,200) (712.800)| (748.800) 6 Sales revenue 1,062,000 990,000 936,000 || Contribution Margin 991,200 475,200 374.400 7 Variable costs (236,000) (594.000) (624.000| Less: Fixed Costs (504.000) (280,000) (92.000) 8 Contribution Margin 826,000 396,000 312.000 Net Income 487,200 195,200 282,400 9 Fixed Costs (504,000) (280.000) (92,000) 10 Net Income 322.000 116,000 220.000 Calculation of %age change in Net Income 11 Particulars Skin Cream Bath Oil Color Gel 12 Increase in Sales 20% Net Income after increase in sales 487,200 195,200 282.400 Less: Net Income as before 322,000 116,000 220.000 14 Calculation of Margin of safety as a %age Increase in Net Income 165,200 79,200 62.400 15 Particulars Skin Cream Bath Oil Color Gel || %age change in Net Income 51.30% 68.28% 28.36% 16 Contribution Margin 826,000 396,000 312.000 17 Sales Revenue 1,062.000 990.000 936,000 Computation of Operating Leverege 18 Contribution margin Ratio 77.78% 40.00% 33.33% Particulars Skin Cream Bath Oil Color Gel 19 Net Income 322,000 116,000 220.000 || Contribution Margin 826,000 396,000 312.000 20 Margin of Safety 414,000 290,000 660,000 Net Income 322.000 116,000 220,000 21 Margin of safety as a %age 38.98% 29.29% 70.51% Operating Leverage 2.57 3.41 1.42 If the mgt. is pessimistic and risk and averse it would choose the If the Mgt. is optimistic and risk aggressive, it would choose the product with product with highest margin of safety highest Operating Leverage 22