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

Sales (13,500 units × $30 per unit)	$	405,000
Variable expenses		243,000
Contribution margin		162,000
Fixed expenses		180,000
Net operating loss	$	(18,000	)

Required:
1. Compute the company’s CM ratio and its break-even point in unit sales and dollar sales.

2. The president believes that a $6,900 increase in the monthly advertising budget, combined with an intensified effort by the sales staff, will result in an $89,000 increase in monthly sales. If the president is right, what will be the increase (decrease) in the company’s monthly net operating income?

3. Refer to the original data. The sales manager is convinced that a 10% reduction in the selling price, combined with an increase of $34,000 in the monthly advertising budget, will double unit sales. If the sales manager is right, what will be the revised net operating income (loss)?

4. Refer to the original data. The Marketing Department thinks that a fancy new package for the laptop computer battery would grow sales. The new package would increase packaging costs by 0.60 cents per unit. Assuming no other changes, how many units would have to be sold each month to attain a target profit of $4,100?

5. Refer to the original data. By automating, the company could reduce variable expenses by $3 per unit. However, fixed expenses would increase by $59,000 each month.
a. Compute the new CM ratio and the new break-even point in unit sales and dollar sales.

b. Assume that the company expects to sell 20,300 units next month. Prepare two contribution format income statements, one assuming that operations are not automated and one assuming that they are. (Show data on a per unit and percentage basis, as well as in total, for each alternative.)

c. Would you recommend that the company automate its operations (Assuming that the company  expects to sell 20,300)?

Explanation

1.
The CM ratio is 40%.

	Total		Per Unit		Percent of Sales
Sales (13,500 units)	$	405,000	$	30.00	100	%
Variable expenses		243,000		18.00	60	%
Contribution margin	$	162,000	$	12.00	40	%

The break-even point is:

Profit	= Unit CM × Q – Fixed expenses
$0	= ($30 − $18) × Q − $180,000
$0	= ($12) × Q − $180,000
$12Q	= $180,000
Q	= $180,000 ÷ $12
Q	= 15,000 units

15,000 units × $30 per unit = $450,000 in sales

2.

Incremental contribution margin:
$89,000 increased sales × 0.40 CM ratio	$	35,600
Less increased advertising cost		6,900
Increase in monthly net operating income	$	28,700

Since the company is now showing a loss of $18,000 per month, if the changes are adopted, the loss will turn into a profit of $10,700 each month ($28,700 − $18,000 = $10,700).

3.

Sales (27,000 units @ $27.00 per unit*)	$	729,000
Variable expenses
(27,000 units @ $18 per unit)	$	486,000
Contribution margin		243,000
Fixed expenses ($180,000 + $34,000)		214,000
Net operating income	$	29,000

*$30.00 − ($30.00 × 0.10) = $27.00
  4.

Profit	= Unit CM × Q – Fixed expenses
$4,100	= ($30.00 − $18.60*) × Q − $180,000
$4,100	= ($11.40) × Q − $180,000
$11.40Q	= $184,100
Q	= $184,100 ÷ $11.40
Q	= 16,149 units

*$18.00 + $0.60 = $18.60.

5.
a.
The new CM ratio would be:

	Per Unit		Percent of Sales
Sales	$	30.00	100	%
Variable expenses		15.00	50	%
Contribution margin	$	15.00	50	%

The new break-even point would be:

Unit sales to break even	=	Fixed expenses
		Unit contribution margin

	=	$180,000 + $59,000
		$15.00

= 15,933 units

Dollar sales to break even	=	Fixed expenses
		CM ratio

	=	$180,000 + $59,000
		0.50

= $478,000

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 0.50). The higher CM ratio means that once the break-even point is reached, profits will increase more rapidly than at present. If 20,300 units are sold next month, for example, the higher CM ratio will generate $1,900 (= $65,500 – $63,600) 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.

Thanks