91Ó°ÊÓ

Garrett Manufacturing sold 410,000 units of its product for \(\$ 68\) per unit in 2017 Variable cost per unit is \(\$ 60,\) and total fixed costs are \(\$ 1,640,000\) 1\. Calculate (a) contribution margin and (b) operating income. 2\. Garrett's current manufacturing process is labor intensive. Kate Schoenen, Garrett's production manager, has proposed investing in state-of-the-art manufacturing equipment, which will increase the annual fixed costs to \(\$ 5,330,000\). The variable costs are expected to decrease to \(\$ 54\) per unit. Garrett expects to maintain the same sales volume and selling price next year. How would acceptance of Schoenen's proposal affect your answers to (a) and (b) in requirement 1? 3\. Should Garrett accept Schoenen's proposal? Explain.

Step by step solution

01

Calculate current contribution margin and operating income

(a) To calculate the contribution margin, we will first find the total contribution made by each unit sold. The contribution margin per unit is the selling price of each unit minus the variable cost per unit. Contribution Margin per Unit = Selling Price - Variable Cost per Unit Then, we will multiply the contribution margin per unit by the total units sold to find the total contribution margin. Total Contribution Margin = Contribution Margin per Unit * Total Units Sold (b) Operating income can be calculated using the following formula: Operating Income = Total Contribution Margin - Total Fixed Costs

02

Calculate new contribution margin and operating income with new manufacturing equipment

(a) We first need to calculate the new contribution margin per unit by considering the new variable cost per unit. New Contribution Margin per Unit = Selling Price - New Variable Cost per Unit Then, we can find the new total contribution margin by multiplying the new contribution margin per unit by the total units sold. New Total Contribution Margin = New Contribution Margin per Unit * Total Units Sold (b) Lastly, we will calculate the new operating income with the new total contribution margin and increased fixed costs. New Operating Income = New Total Contribution Margin - New Total Fixed Costs

03

Analyse the results and make a recommendation

After comparing the operating incomes calculated in Step 1 and Step 2, we can make a recommendation on whether Garrett Manufacturing should accept Schoenen's proposal to invest in new manufacturing equipment or not, considering the financial implications of the decision. Now, let's perform the calculations:

04

Calculations

(a) Contribution Margin per Unit = Selling Price - Variable Cost per Unit = \$68 - \$60 = \$8 Total Contribution Margin = Contribution Margin per Unit * Total Units Sold = \$8 * 410,000 = \$3,280,000 (b) Operating Income = Total Contribution Margin - Total Fixed Costs = \$3,280,000 - \$1,640,000 = \$1,640,000

05

Calculations

(a) New Contribution Margin per Unit = Selling Price - New Variable Cost per Unit = \$68 - \$54 = \$14 New Total Contribution Margin = New Contribution Margin per Unit * Total Units Sold = \$14 * 410,000 = \$5,740,000 (b) New Operating Income = New Total Contribution Margin - New Total Fixed Costs = \$5,740,000 - \$5,330,000 = \$410,000

06

Analysis and Recommendation

Comparing the operating incomes, we can see that the current operating income is \$1,640,000, while the operating income after implementing the proposed changes would be \$410,000. Therefore, based on these calculations, accepting Schoenen's proposal will result in a decrease in the operating income. Hence, it is not recommended for Garrett Manufacturing to accept Schoenen's proposal to invest in new manufacturing equipment, as the financial benefits do not justify the increased fixed costs and the reduced operating income. However, it's important to consider other factors like long-term savings, non-financial benefits, and overall business strategy before making the final decision.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Contribution Margin

Understanding the contribution margin is key to determining how much profit a company makes on its products after covering variable costs. The contribution margin per unit is calculated by subtracting the variable cost per unit from the selling price. In Garrett Manufacturing's case, the selling price per unit is \( \\(68 \), and the variable cost per unit is \( \\)60 \). Therefore, the contribution margin per unit is \( \\(8 \).
The total contribution margin then sums up the contribution from all units sold. For Garrett, with 410,000 units sold, this amounts to \( \\)3,280,000 \) (\( \$8 \times 410,000 \)).
A higher contribution margin indicates that more money is available to cover fixed costs and contribute to net income after all variable costs are paid.

Operating Income

Operating income is the profit left after deducting all fixed costs from the total contribution margin. It provides insight into the company's core business profitability without considering other income and expenses like interest or taxes. For Garrett Manufacturing, the operating income was calculated as follows:
Given a total contribution margin of \( \\(3,280,000 \) and fixed costs of \( \\)1,640,000 \), the operating income is \( \$1,640,000 \).

• This figure allows companies to understand their ability to generate profit from regular operations.
• A consistent operating income is a sign of sustainable business practices.

Operating income can help business leaders make decisions about cost control and operational efficiency.

Fixed Costs

Fixed costs are expenses that remain constant, regardless of the number of units produced. These include things like rent, salaries, and depreciation. In the context of Garrett Manufacturing, the fixed costs were initially \( \\(1,640,000 \), but could increase to \( \\)5,330,000 \) with the new equipment proposed by Kate Schoenen.

• Unlike variable costs, fixed costs do not change with the level of production or sales.
• Having high fixed costs requires careful consideration in pricing and cost control strategies as it influences how much production must be achieved to break even.

As fixed costs increase, the company either has to increase sales or reduce costs elsewhere to maintain or increase profits.

Variable Costs

Variable costs change with the level of output. They include costs for raw materials, labor directly involved in manufacturing, and other costs that fluctuate with production. Garrett Manufacturing's current variable cost is \( \\(60 \) per unit, which Kate Schoenen proposes to reduce to \( \\)54 \) per unit with new equipment.

• Lowering variable costs can increase the contribution margin and overall profitability.
• It offers flexibility as they directly correlate with production levels; more production means higher variable costs and vice versa.

Reducing variable costs can be an efficient way to improve profitability, assuming fixed costs do not increase disproportionately, as seen in Schoenen's proposal.