Question

Please show all steps with formulas. I have viewed other answers, however, I do not think wage is a variable cost. Let me know what you think. I will up vote for good content - thank you!

Case ON-THE-GO: Cost-Volume-Profit Analysis Peter Kankel, the CFO of On-the-Go convenience stores, had only a couple of hours to decide what he would recommend. Decisions to add products are often challenging. Kankel knows that modern convenience stores have to do more than just remain open late into the evening and offer a diverse product assortment; they have to change with the times or face extinction. Over the years, On-the-Go has stocked new products and services, such as gasoline, lottery tickets, and even Internet shopping and delivery services. A walk through any of its stores is likely to reveal in excess of 2,000 different products and services, often available 24 hours a day, seven days a week. There are close to 150,000 convenience stores scattered across the United States. The industry generated $350 billion in sales for 2011 On-the-Go Stores, based in Newport, Rhode Island, operates 82 stores in its chain of conve- nience stores. Locations are primarily in the New England and Mid-Atlantic regions of the United States, where there are about 20,000 convenience stores -- approximately 13% of the country's total. The average sale is $3.00, with a gross margin of 30%. Recently, On-the-Go has faced some challenging decisions. For example, company man- agers recently evaluated the effect on income of the store's sales mix and performed sensitivity analysis to see the effect on operating income of changing the selling price of milk. Kankel was currently evaluating two major decisions. The first decision related to the sale of money orders at its stores. This was a new product area for the company-a "financial service," much like what a bank would offer. By offering this new service, On-the-Go hoped to boost its customer count. Previous studies had shown that customers were likely to buy more than just the items they originally intended to purchase. So, On-the-Go wanted to boost sales revenue by giving customers another reason to come into the store--and buy more than intended. Kankel had obtained the following information. The cost of renting the machine for each store to prepare money orders is $30 per month. The lease rent for the store is $5.000. For each money order processed, On-the-Go would pay a processing fee of 6 cents. After conducting an informal survey of banks and other local businesses that offered money order services, On-the- Go found that most charged 99 cents for each money order transaction. On-the-Go planned to set its money order fee at 79 cents to undercut local competition. Kankel estimated that a money order transaction would take one counter clerk 90 seconds to complete, versus only 30 seconds for ringing up a product sale. The average hourly wage for a store clerk is $12.00 per hour. On-the-Go does not plan to hire any new clerks or ask existing clerks to work longer hours if it decides to sell money orders. Kankel then turned to the second major decision he faced: Should On-the-Go sell in-store deli sandwiches to lunchtime customers? If it chose to sell deli sandwiches, On-the-Go could either prepare these sandwiches in-store or purchase prepackaged deli sandwiches from an outside vendor. It would cost $3.50 to purchase the sandwiches. If it made the sandwiches, the cost of the ingredients would be $2.50 per sandwich. One of On-the-Go's senior employees, who is paid $15 per hour, would prepare the sandwiches during the lunch hour. On-the-Go would then have to hire a temporary worker for the 2-hour lunchtime period to manage other activities in the store. The temporary worker would be paid $10 per hour. The average selling price of a del Sandwich is $4.50. On-the-Go anticipates selling 12 sandwiches per hour. All other costs would bo unchanged whether On-the-Go buys the sandwiches, makes the sandwiches, or chooses not to sell sandwiches at all,

Answer 1

ON-THE-GO: Cost-Volume Profit Analysis

1a.      Contribution margin per unit for money orders:

Selling price:	79.0 cents
Deduct:	6.0 cents
Processing fee
Contribution margin	73.0 cents per unit

The instructor should ask students why costs of the counter clerks are not included in variable costs since counter clerks are paid by the hour. The reason is that the costs of the counter clerks will not change since new clerks would not be hired and existing clerks would not be asked to work longer hours as a result of introducing the service. The service time needed to process the money orders is expected to simply reduce the time that counter clerks are idle waiting for customers to check out.

All other costs such as the cost of renting the machine of $30 per month and the lease rent of the store of $5,000 per month are fixed costs and not variable costs and hence not included when calculating the contribution margin per unit.

1b.       Break even calculation using the equation method:

Revenues – Variable costs – Fixed costs (FC) = Operating income (OI) Where

(Unit selling price × quantity (Q)) – (Unit variable costs × Q) – Fixed costs = OI

                                       

$0.79Q – $0.06Q – $30.00 = $0

$0.73Q – $30.00 = $0

$0.73Q = $30.00

Q = $30.00/$0.73 = 41.10 money orders (approximately 1 per day)

Break even calculation using the contribution margin method: $30.00/$0.73 per unit = 41.10 units per month

The instructor may want to ask students why the fixed cost of lease rent of the store of $5,000 is excluded from the break even calculations. The answer is that the question only asks about the break even number of money orders should the service be introduced and so only the fixed costs of providing the money order service should be included.

1c.       Revenues – Variable costs – Fixed costs (FC) = Operating income (OI)

$0.79Q – $0.06Q	– $30.00	= $140
$0.73Q	– $30.00	= $140
	$0.73Q	= $140 + $30.00 = $170

Q = $170.00/$0.73 = 232.88 money orders per month (approximately 8 per day)

2.

Incremental operating income per 2-hour period each day if On-the-Go buys and sells 24 sandwiches from an outside vendor (12 sandwiches per hour × 2 hours):

Sales ($4.50 × 24 sandwiches)	$108
Variable costs ($3.50 × 24 sandwiches)		84
Operating income	$ 24

Incremental operating income per 2-hour period each day if On-the-Go makes 24 sandwiches in-

House
Sales ($4.50 × 24 sandwiches)	$108
Variable costs of ingredients ($2.50 × 24 sandwiches)	60
Cost of temporary worker ($10 per hour × 2 hours)		20
Total operating cost		80
Operating income	$ 28

The instructor may wish to ask students why the cost of labor used in the calculation is the $10 per hour paid to the temporary worker rather than the $15 per hour paid to the senior employee who is actually making the sandwiches. The reason is that the cost of the senior employee is a fixed cost that would be incurred regardless of whether On-the-Go sells deli sandwiches or not. The additional cost of making the deli sandwiches is the cost of the temporary worker hired so that On-the-Go can make Deli sandwiches. It is not relevant that the temporary worker is not the one actually making the sandwiches.

On-the-Go should sell deli sandwiches. It is more profitable for On-the-Go to hire a temporary worker for the 2-hour lunch period to allow the senior employee to make the sandwiches rather than purchase the sandwiches from an outside vendor.

Students should discuss other factors that Peter Kankel may want to consider before deciding to sell deli sandwiches. Can the deli sandwich station be set up in a way that does not affect the flow of traffic in the store? Selling deli sandwiches should not disrupt the shopping of customers looking for other products. Will selling deli sandwiches reduce sales of other products? Can the temporary worker provide the same service as the senior employee for the other activities?

If the deli sandwiches are made in-house, can they be produced at the same level of quality as the sandwiches purchased from outside? An argument for making the sandwiches in-house is that they are likely to be fresher than if the sandwiches were purchased from outside.

3.

Incr. optg. income from selling 300 money orders per month ($0.73 × 300) – $30 $ 189 Incr. optg. income per 30-day month from selling 24 deli sandwiches per day ($28×30)		840
Total increase in operating income from selling money orders and deli sandwiches	$1,029

From a financial viewpoint, selling money orders and deli sandwiches increases On-the-Go’s operating income. In making his final recommendation, however, Peter Kankel needs to take into account the comments made by John Lefarge and Susan Polk. From Lefarge’s point of view, adding these products is profitable in its own right

but On-the-Go might earn additional operating income from sales of other products when customers come in for money orders or deli sandwiches. For example, customers who might be attracted to money order services include those new to the location who don’t have a bank checking account, or those who do not wish to establish a relationship with a bank for financial services. In the Northeast, On-the-Go operates in neighborhoods with large immigrant populations whose members have yet to open bank checking accounts. These customers are also likely to buy On-the-Go’s other products once they are in the store, for example a drink to go with the sandwich.

Some students will raise the concerns suggested by Susan Polk’s comments. For example, since it takes three times as long for a clerk to complete a money order transaction versus a typical product sale (90 seconds versus 30 seconds), customers who are not purchasing money orders will have to wait three times longer while the money order transaction is being completed. Some customers may choose not to wait, thereby costing the store those sales. It is difficult to calculate the exact cost since the number of customers who might leave and the contribution margin for the average $3.00 sale is not known. Students may try to calculate the cost using the gross margin percentage of 30%, and an estimate of the variable operating costs such as the labor of the store clerk. Some reports about the convenience store industry indicate that 40% of shoppers walk out of a convenience store due to long checkout lines costing the industry over a billion dollars a year. On-the-Go may want to track customers coming to the store each hour to determine peak traffic times that could be used to justify additional staffing to cover those busy hours. If the stores have security cameras the video could be used to track customers to identify the busy periods.

Instructors may also want to have students discuss Polk’s arguments that the cost of making deli sandwiches should be calculated using the wage rate of the senior employee of $15 per hour rather than the wage rate of the temporary worker at $10 per hour used in the calculation in question 2. The arguments why this is not correct has already been discussed in question 2. The only additional point that can be made here is that if the temporary worker were not hired the senior employee would have been stocking shelves and been paid $15 per hour for doing so.