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Chapter 3: Problem 24

The Deli-Sub Shop owns and operates six stores in and around Minneapolis. You are given the following corporate budget data for next year: $$\begin{array}{lr}\text { Revenues } & \$ 11,000,000 \\\\\text { Fixed costs } & \$ 3,000,000 \\\\\text { Variable costs } & \$ 7,500,000\end{array}$$ Variable costs change based on the number of subs sold. Compute the budgeted operating income for each of the following deviations from the original budget data. (Consider each case independently.) 1\. \(A 10 \%\) increase in contribution margin, holding revenues constant 2\. \(A\) 10 \(\%\) decrease in contribution margin, holding revenues constant 3\. \(A 5 \%\) increase in fixed costs 4\. \(A\) 5\% decrease in fixed costs 5\. A \(5 \%\) increase in units sold 6\. \(A 5 \%\) decrease in units sold 7\. \(A 10 \%\) increase in fixed costs and a \(10 \%\) increase in units sold 8\. \(A 5 \%\) increase in fixed costs and a \(5 \%\) decrease in variable costs 9\. Which of these alternatives yields the highest budgeted operating income? Explain why this is the case.

Short Answer

Expert verified
The highest budgeted operating income comes from a 10% increase in contribution margin, holding revenues constant. This is because increasing the contribution margin means that the shop retains more money for each unit sold, leading to a higher operating income while keeping revenues constant.

Step by step solution

01

Find the Initial Operating Income

First, find the initial operating income using the formula Operating Income = Revenues - Fixed Costs - Variable Costs. Initial Operating Income: \(\$11,000,000\) - \(\$3,000,000\) - \(\$7,500,000\)
02

Find the Contribution Margin

Contribution Margin = Revenues - Variable Costs Initial Contribution Margin: \(\$11,000,000\) - \(\$7,500,000\)
03

Apply each deviation to the original budget data individually and compute the new operating income

1\. For 10% increase in contribution margin, holding revenues constant: New Contribution Margin: Initial Contribution Margin * 1.10 New Operating Income: Revenues - Fixed Costs - New Contribution Margin 2\. For 10% decrease in contribution margin, holding revenues constant: New Contribution Margin: Initial Contribution Margin * 0.90 New Operating Income: Revenues - Fixed Costs - New Contribution Margin 3\. For 5% increase in fixed costs: New Fixed Costs: Fixed Costs * 1.05 New Operating Income: Revenues - New Fixed Costs - Variable Costs 4\. For 5% decrease in fixed costs: New Fixed Costs: Fixed Costs * 0.95 New Operating Income: Revenues - New Fixed Costs - Variable Costs 5\. For 5% increase in units sold, find the new revenue and variable costs: New Revenue: Revenues * 1.05 New Variable Costs: Variable Costs * 1.05 New Operating Income: New Revenue - Fixed Costs - New Variable Costs 6\. For 5% decrease in units sold, find the new revenue and variable costs: New Revenue: Revenues * 0.95 New Variable Costs: Variable Costs * 0.95 New Operating Income: New Revenue - Fixed Costs - New Variable Costs 7\. For 10% increase in fixed costs and 10% increase in units sold, find the new fixed costs, revenue, and variable costs: New Fixed Costs: Fixed Costs * 1.10 New Revenue: Revenues * 1.10 New Variable Costs: Variable Costs * 1.10 New Operating Income: New Revenue - New Fixed Costs - New Variable Costs 8\. For 5% increase in fixed costs and 5% decrease in variable costs, find the new fixed costs and new variable costs: New Fixed Costs: Fixed Costs * 1.05 New Variable Costs: Variable Costs * 0.95 New Operating Income: Revenues - New Fixed Costs - New Variable Costs
04

Compare operating incomes and determine the highest

Compare the budgeted operating incomes for each alternative and determine which one yields the highest operating income. Write a brief explanation of why that alternative is the best for maximizing budgeted operating income.

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Key Concepts

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

Understanding Contribution Margin
The contribution margin represents the portion of sales revenue that is not consumed by variable costs and thus contributes to covering fixed costs. It is a vital metric for managers to understand how much each product sold contributes to profits after accounting for the variable costs to produce and sell the product. Think of it as the leftover revenue after all the variable expenses are paid off.

Imagine a shop selling subs. If a sub is sold at \(5 and the ingredients or variable costs sum up to \)2, the contribution margin for that sub would be $3. If you multiply this by the total number of subs sold, you get the total contribution margin, which helps in covering the fixed costs and potentially generating profit.

To improve the scenario from the exercise: when the Deli-Sub Shop experiences a 10% increase in the contribution margin, while holding revenues constant, it effectively earns more per sub sold without an increase in sales. This could result from decreased variable costs or increased sub prices. Both cases would lead to higher profits as long as the sales volume remains steady.
Navigating Fixed Costs
Fixed costs, unlike variable costs, do not vary with production or sales levels. These are expenses that remain constant regardless of how much the business is producing or selling. Examples include rent, salaries of permanent staff, and depreciation of equipment. Even if the Deli-Sub Shop doesn't sell a single sub, it would still incur these costs.

So, why are fixed costs important to understand? They form a significant part of the budgeted operating income calculation since they, along with variable costs, are subtracted from revenues.

Let's apply this to the exercise at hand. An increase in fixed costs, such as a rise in rent, means that the Deli-Sub Shop needs to generate more revenue or reduce other costs to maintain its operating income. Conversely, a decrease in fixed costs straightaway improves the operating income, as there's less expense to offset against revenue. This can come from renegotiated contracts or improved efficiency.
Variable Costs and their Impact
Variable costs are those which fluctuate directly with the level of output or sales. For the Deli-Sub Shop, these costs would include the ingredients for subs, packaging, and perhaps even some forms of labor if they are paid on a per-sub basis. Typically, the more you sell, the higher your variable costs will be.

Understanding and managing variable costs is crucial because they affect the contribution margin. If the variable costs increase, the contribution margin decreases, meaning less revenue is left to cover fixed costs and generate profit. On the flip side, if the Deli-Sub Shop can decrease its variable costs, for instance by negotiating better prices with suppliers or improving operational efficiencies, it can sell subs at the same price but keep more of the revenue, leading to a higher operating income.

From the exercise, a 5% decrease in variable costs while increasing fixed costs results in a net positive effect on the budgeted operating income. The savings on variable costs help to offset the extra expenses due to the increase in fixed costs.

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Most popular questions from this chapter

"In CVP analysis, gross margin is a less-useful concept than contribution margin." Do you agree? Explain briefly.

Westover Motors is a small car dealership. 0 n average, it sells a car for 32,000, which it purchases from the manufacturer for 28,000 .Each month, Westover Motors pays 53,700 in rent and utilities and 69,000 for salespeople's salaries. In addition to their salaries, salespeople are paid a commission of 400 for each car they sell. Westover Motors also spends 10,500 each month for local advertisements. Its tax rate is 40 \% 1\. How many cars must Westover Motors sell each month to break even? 2\. Westover Motors has a target monthly net income of 69,120 .What is its target monthly operating income? How many cars must be sold each month to reach the target monthly net income of 69,120 ?

Chartz \(1-2-3\) is a top-selling electronic spreadsheet product Chartz is about to release version \(5.0 .\) It divides its customers into two groups: new customers and upgrade customers (those who previously purchased Chartz \(1-2-34.0\) or earlier versions). Although the same physical product is provided to each customer group, sizable differences exist in selling prices and variable marketing costs: $$\begin{array}{cccc} & \text { New Customers } & \text { Upgrade Customers } \\ \hline \text { Selling price } & & \$ 195 & \$ 115 \\\\\text { Variable costs } & & & \\\\\text { Manufacturing } & \$ 15 & & \$ 15 \\\\\text { Marketing } & 50 & 65 & 20 & 35 \\\\\text { Contribution margin } & & \$ 130 & & \$ 80 \\\\\hline\end{array}$$ The fixed costs of Chartz \(1-2-35.0\) are \(\$ 16,500,000 .\) The planned sales mix in units is \(60 \%\) new customers and \(40 \%\) upgrade customers. 1\. What is the Chartz \(1-2-35.0\) breakeven point in units, assuming that the planned \(60 \% / 40 \%\) sales mix is attained? 2\. If the sales mix is attained, what is the operating income when 170,000 total units are sold? 3\. Show how the breakeven point in units changes with the following customer mixes: a. \(\mathrm{New} 40 \%\) and upgrade \(60 \%\) b. \(\mathrm{New} 80 \%\) and upgrade \(20 \%\) c. Comment on the results.

Describe the assumptions underlying CVP analysis.

Kindmart is an international retail store. Kindmart's managers are considering implementing a new business-to-business (B2B) information system for processing merchandise orders. The current system costs Kindmart \(\$ 2,000,000\) per month and \(\$ 55\) per order. Kindmart has two options, a partially automated B2B and a fully automated B2B system. The partially automated B2B system will have a fixed cost of \(\$ 6,000,000\) per month and a variable cost of \(\$ 45\) per order. The fully automated B2B system has a fixed cost of \(\$ 14,000,000\) per month and a variable cost of \(\$ 25\) per order. Based on data from the past two years, Kindmart has determined the following distribution on monthly orders: $$\begin{array}{cc} \text { Monthly Number of Orders } & \text { Probability } \\ \hline 300,000 & 0.25 \\ 500,000 & 0.45 \\ 700,000 & 0.30 \end{array}$$ 1. Prepare a table showing the cost of each plan for each quantity of monthly orders. 2\. What is the expected cost of each plan? 3\. In addition to the information system's costs, what other factors should Kindmart consider before deciding to implement a new B2B system?
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