Question

Three entrepreneurs were looking to start a new brewpub near Sacramento, California, called Roseville Brewing Company (RBC). Brewpubs provide two products to customers-food from the restaurant segment and freshly brewed beer from the beer production segment. Both segments are typically in the same building, which allows customers to see the beer brewing process. After months of research, the owners created a financial model that showed the following projections for the first year of operations. Sales Beer sales $ 781.200 Food sales 1,074,150 97.650 Other sales Total sales Less cost of sales Gross margin Less marketing and administrative expenses Operating profit $1,953,000 525.358 $1.427,642 1,125,430 $ 302.212

Answer 1

a.   Potential investors and bankers were concerned about the accuracy of the income statement projections.  They wanted to know what would happen if the projections were overly optimistic.  Operating profit was heavily influenced by projected sales dollars and product mix.  The concern was over the impact changes in sales and product mix (among other things) might have on operating profit.

b.   The first income statement was in the traditional format.  In the traditional format, costs are not shown according to cost behavior.  Thus, it is difficult to predict what will happen with costs as changes are made in sales volume.  For example, if sales volume decreases by 10 percent, it is difficult to predict what will happen with cost of sales and marketing and administrative expenses.  Will they decrease by the same percentage?  (Unlikely unless all costs are variable!)

c.   The best way to quickly check for reasonableness is to compare the operating profit as a percentage of sales to other similar businesses.  In addition, the dollar amount of operating profit can be compared to other similar businesses of roughly the same size.  (In fact, the banks and investors who were approached by RBC often looked at these two items as a starting point to ensure the projected income statement was reasonable.)

d.   The cost of a pint of beer can range from $0.15 to $1.40 depending on what is included in the cost.  Should we include only the materials?  Should we include direct labor?  Indirect labor?  Manufacturing overhead?  The point is to understand what is included in the cost of a product, particularly when this information is used for pricing and other forms of decision-making.

e.   (1) The breakeven point in sales dollars is $1,235,154, calculated as follows:

           

Breakeven point	=	Total fixed costs ÷ contribution margin ratio
	=	$520,000 ÷ ($822,212 ÷ $1,953,000)
	=	$520,000 ÷ .421
	=	$1,235,154.

      (2) The margin of safety is $717,846, calculated as follows:

Margin of safety	=	$1,953,000 – $1,235,154
		$717,846.

      (3) RBC is selling many different products that change daily.  It is difficult if not impossible, to measure units of product for a brew pub.  This same argument holds true for most service companies as well.  Service companies do not sell “units” of service.  Thus, for these types of companies, breakeven points and target profit points are calculated using sales dollars.

     

      (4) The sales dollars required to achieve $200,000 in operating profit is $1,710,214, calculated as follows:

Target profit	=	Total fixed costs + Target profit
Contribution margin ratio

                        = ($520,000 + $200,000) ÷ .421

                        = $720,000 ÷ .421

                        = $1,710,214.

      The sales dollars required to achieve $500,000 in operating profit is $2,422,803, calculated as follows:

                        = ($520,000 + $500,000) ÷ .421

                        = $1,020,000 ÷ .421

                        = $2,422,803.

      These calculations assume that the product mix is constant.  The contribution margin ratio is dependent on the product mix, and will change as the product mix changes.