Due to erratic sales of its sole product—a high-capacity battery for laptop computers—PEM, Inc., has been experiencing difficulty for some time. The company’s contribution format income statement for the most recent month is given below:

Due to erratic sales of its sole product—a high-capacity battery for laptop computers—PEM, Inc., has been experiencing difficulty for some time. The company’s contribution format income statement for the most recent month is given below:

 

Sales (13,500 units × $20 per unit)	$	270,000
Variable expenses		162,000
Contribution margin		108,000
Fixed expenses		120,000
Net operating loss	$	(12,000)

 

Required:

1.

Compute the company’s CM ratio and its break-even point in both unit sales and dollar sales. Explanation: 1. The CM ratio is 40%.   Total   Per Unit Percent of Sales   Sales (13,500 units) $ 270,000    $ 20    100 %   Variable expenses   162,000      12    60 %     Contribution margin $ 108,000    $ 8    40 %   The break-even point is: Profit  = Unit CM × Q − Fixed expenses $0  = ($20 − $12) × Q − $120,000 $0  = ($8) × Q − $120,000 $8Q  = $120,000 Q  = $120,000 ÷ $8 Q  = 15,000 units 15,000 units × $20 per unit = $300,000 in sales Alternative solution: Unit sales to break even   = Fixed expenses Unit contribution margin           = $120,000      $8.00           = 15,000 units Dollar sales to break even   = Fixed expenses CM ratio           = $120,000      0.40           = $300,000 in sales 2.         Incremental contribution margin:         $81,000 increased sales × 40% CM ratio $ 32,400      Less increased advertising cost   6,100        Increase in monthly net operating income $ 26,300      Since the company is now showing a loss of $12,000 per month, if the changes are adopted, the loss will turn into a profit of $14,300 each month ($26,300 less $12,000 = $14,300). 3. Sales: (27,000 units @ $18.00 per unit*) = $486,000 Variable expenses: (27,000 units @ $12 per unit) = $324,000   Fixed expenses: ($120,000 + $31,000) = $151,000   *$20.00 - ($20.00 × 0.10) = $18.00 4. Profit  = Unit CM × Q − Fixed expenses $4,400  = ($20.00 − $12.70*) × Q − $120,000 $4,400  = ($7.30) × Q − $120,000 $7.30Q  = $124,400 Q  = $124,400 ÷ $7.30 Q  = 17,041 units *$12.00 + $0.70 = $12.70. Alternative solution: Unit sales to attain target profit = Target profit + Fixed expenses CM per unit           = $4,400 + $120,000 $7.30**              = 17,041 units **$20.00 − $12.70 = $7.30 5. a. The new CM ratio would be:   Per Unit Percent of Sales   Sales $ 20        100%       Variable expenses   6        30%         Contribution margin $ 14        70%       The new break-even point would be: Unit sales to break even = Fixed expenses Unit contribution margin   = $120,000 + 52,000 $14.00   = 12,286 units Dollar sales to break even = Fixed expenses CM ratio   = $120,000 + 52,000 0.70   = $245,714 c. Whether or not the company should automate its operations depends on how much risk the company is willing to take and on prospects for future sales. The proposed changes would increase the company’s fixed costs and its break-even point. However, the changes would also increase the company’s CM ratio (from 0.40 to 0.70). The higher CM ratio means that once the break-even point is reached, profits will increase more rapidly than at present. If 20,000 units are sold next month, for example, the higher CM ratio will generate $68,000 more in profits than if no changes are made.   The greatest risk of automating is that future sales may drop back down to present levels (only 13,500 units per month), and as a result, losses will be even larger than at present due to the company’s greater fixed costs. (Note the problem states that sales are erratic from month to month.) In sum, the proposed changes will help the company if sales continue to trend upward in future months; the changes will hurt the company if sales drop back down to or near present levels.