Data for Hermann Corporation are shown below:

Data for Hermann Corporation are shown below:

	Per Unit				Percent of Sales
Selling price	$	115				100	%
Variable expenses		69				60
Contribution margin	$	46				40	%

Fixed expenses are $83,000 per month and the company is selling 2,500 units per month.

Required:

1-a. How much will net operating income increase (decrease) per month if the monthly advertising budget increases by $8,800 and monthly sales increase by $19,000?

1-b. Should the advertising budget be increased?

 

Explanation

1-a. & 1-b.

The following table shows the effect of the proposed change in monthly advertising budget:

	Current Sales		Sales with Additional Advertising Budget		Difference
Sales	$	287,500	$	306,500	$	19,000
Variable expenses		172,500		183,900		11,400
Contribution margin		115,000		122,600		7,600
Fixed expenses		83,000		91,800		8,800
Net operating income	$	32,000	$	30,800	$	(1,200	)

Assuming no other important factors need to be considered, the increase in the advertising budget should not be approved because it would lead to a decrease in net operating income of $1,200.

2-a. Refer to the original data. How much will net operating income increase (decrease) per month if the company uses higher-quality components that increase the variable expense by $5 per unit and increase unit sales by 15%.

2-b. Should the higher-quality components be used?

2-a.

The $5 increase in variable expense will cause the unit contribution margin to decrease from $46 to $41 with the following impact on net operating income:

Expected total contribution margin with the higher-quality components: 2,500 units × 1.15 × $41 per unit	$	117,875
Present total contribution margin: 2,500 units × $46 per unit		115,000
Change in total contribution margin	$	2,875

2-b.

Assuming no change in fixed expenses, the net operating income will also increase by $2,875. The higher-quality components should be used.

Thanks