# Demonstration Problem 2-2 Effect of Cost Structure

**Demonstration Problem 2-2 Effect of Cost Structure (3 pts.)**

**My Company / Your Company**

My Company and Your Company provide rafting tours on Big Bear River. My Company pays tour guides fixed salaries. It budgets salaries expense at $160,000 per year. Your Company pays tour guides $40 per rafter served. Rafters are charged $50 per tour. Both companies expect to carry approximately 4,000 rafters during the year.

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a. Prepare budgeted annual income statements for the two companies.

b. In an effort to lure rafters away from Your Company, My Company lowers the price per rafter to $39. Prepare revised income statements for both companies. Assume that My Company serves 6,000 rafters who each pay $39 per tour, while Your Company serves only 2,000 rafters who pay $50 per tour.

d. Suppose Your Company matches the $39 price set by My Company. Prepare income statements for both companies assuming that each company serves 4,000 customers.

**Demonstration Problem 2-2 Work Papers**

**a.**

MyCompany | YourCompany | ||||

Number of Rafters | 4,000 | 4,000 | |||

Revenue | |||||

Cost of Guides My Company | Fixed | ||||

Cost of Guides Your Company | Variable | ||||

Net income | |||||

**b.**

MyCompany | YourCompany | ||||

Number of Rafters (a) | 6,000 | 2,000 | |||

Revenue My Company | |||||

Revenue Your Company | |||||

Cost of Guides My Company | Fixed | ||||

Cost of Guides Your Company | Variable | ||||

Net Income | |||||

**d.**

MyCompany | YourCompany | ||||

Number of Rafters | 4,000 | 4,000 | |||

Revenue | |||||

Cost of Guides My Company | Fixed | ||||

Cost of Guides Your Company | Variable | ||||

Net Loss | |||||

**Demonstration Problem 2-3 Effect of Operating Leverage (2 pts.)**

Sharon Virgil owns a delivery service company. She charges customers $10 per delivery. The companyA????1s variable expenses average $2 per delivery and fixed costs are $600 per month. Ms. Virgil provided 100 deliveries during the most recent month.

**Required**

a. Prepare an income statement using a contribution margin format.

b. Determine the magnitude of operating leverage. Use your answer to determine the percentage change in net income if sales increase by 10%.

c. Assume that sales increase by 10% (deliveries increase to 110). Prepare a contribution margin format income statement assuming 110 deliveries. Calculate the percentage change in net income and compare your answer with your solution to part b.

**Demonstration Problem 2-3 Work Papers**

**Income Statement Using a Contribution Margin Format, Volume of 100 Deliveries**

Revenue | ||

Variable Expenses | ||

Contribution Margin | ||

Fixed Expenses | ||

Net Income | ||

**Magnitude of Operating Leverage = Contribution Margin A????1 Net Income:**

**$________ A????1 $_________ = ___ times.**

**Therefore, a 10% increase in sales will produce a _________ increase in net income. Similarly, a 10% decrease in sales will produce a __________ decrease in net income.**

**Income Statement Using a Contribution Margin Format, Volume of 110 Deliveries**

Revenue | ||

Variable Expenses | ||

Contribution Margin | ||

Fixed Expenses | ||

Net Income | ||

**(Alternative Net Income – Base Net Income) A????1 Base:**

**($______ – $______) A????1 $______ = _____%**

**Demonstration Problem 3-1 Cost-Volume-Profit Analysis (10)**

Jeff Jamail is evaluating a business opportunity to sell cookware at trade shows. Mr. Jamail can buy the cookware at a wholesale cost of $210 per set. He plans to sell the cookware for $350 per set. He estimates fixed costs such as plane fare, booth rental cost, and lodging to be $5,600 per trade show.

**Required**

a. Determine the number of cookware sets Mr. Jamail must sell at a trade show to break even (zero profit or loss). Use the following structure to answer this question:

**(1) Contribution Margin Per Unit Approach:**

a. Determine the amount of the contribution margin per unit.

b. Explain that when the total contribution margin is sufficient to pay for the fixed cost, Mr. Jamail will break even. Show the computation of break-even in units.

c. Show how to compute the break-even point in number of dollars using the break-even point in units and the selling price.

d. Confirm the results by preparing an income statement.

**(1) Contribution Margin Per Unit Approach**

**(a) Determine the contribution margin per unit.**

Per Unit Contribution Margin | ||

Sales Price | $ | |

$ | ||

**(b) When the total contribution margin is sufficient to pay for the fixed costs, Mr. Jamail will break even. The number of units required to break even can be computed as follows:**

Formula for Computation of Break-Even Point in Units | ||||

$ | ||||

—————————– | = | ———— | = | |

$ | ||||

**(c) The break-even point in number of dollars can be computed as follows:**

Break-Even Point in Sales Dollars | ||

Sales Price Per Unit | $ | |

$ | ||

**(d) Confirm the results by preparing an income statement.**

Income Statement | ||

Sales | $ | |

( ) | ||

( ) | ||

Net Income | $ 0 | |

**(2)** **Contribution Margin Ratio Approach.**

a. Calculate the contribution margin ratio.

b. Use the ratio to calculate the break-even point in sales dollars, then use the results and the selling price to calculate the break-even point in units.

**(2) Contribution Margin Ratio Approach**

**(a) The contribution margin ratio is computed as follows.**

Contribution Margin Ratio | ||||||

Contribution | ||||||

Margin | = | ————————————- | = | —— | = | |

Ratio | ||||||

**(b) Using the contribution margin ratio, calculate the break-even point in sales dollars and units.**

Break-Even Point in Sales Dollars | ||||||

Break-Even | ||||||

in Sales | = | ——————————————– | = | ——— | = | |

Dollars | ||||||

Break-Even Point in Number of Units | ||||||

Break-Even | ||||||

in Units | = | ——————————– | = | ——— | = | |

**(3) Equation Approach.**

a. Calculate the break-even point in units.

b. Calculate the break-even point in sales dollars.

**(3) Equation Approach**

**(a) Use the break-even equation and solve for number of units:**

Break-Even Equation |

**(b) Compute the break-even point in dollars as in part a3 above:**

Break-Even Point in Sales Dollars | ||

Sales Price | $ | |

$ | ||

**b. Assume Mr. Jamail desires to earn a profit of $4,900 per show.**

(1) Determine the sales volume in units (sets of cookware) necessary to earn the desired profit.

(2) Determine the sales volume in dollars necessary to earn the desired profit.

(3) Using the contribution margin format, prepare an income statement to confirm your answers to parts 1 and 2.

**(1) Sales Volume Required to Earn a Desired Profit**

Formula for Computation of Sales Volume Necessary to Earn a Target Profit of $4,900 | ||||

————————————— | = | ——————— | = | |

**(2) Determine the sales volume in dollars required to earn the desired profit.**

Required Sales in Number of Dollars | ||

Sales Price | $ | |

$ | ||

**(3) Confirm the answers by preparing an income statement.**

Income Statement | ||

Sales | $ | |

( ) | ||

( ) | ||

Net Income | $ | |

Determine the margin of safety between the sales volume at the break-even point and the sales volume required to earn the desired profit.Determine the margin of safety both in sales dollars and as a percentage.

**c. Margin of Safety**

**(1) Margin of Safety Expressed in Sales Dollars:**

Margin of Safety | ||

$ | ||

$12,250 | ||

**(2) Margin of Safety Expressed as a Percentage:**

Margin of Safety Percentage | ||||

———————- | = | —————— | = | |