Problem 1129 Margin of safety and operating leverage LO 116

Problem 11-29 Margin of safety and operating leverage LO 11-6 Vernon Company is considering the addition of a new product to its cosmetics line. The company has three distinctly different options: a skin cream, a bath oil, or a hair coloring gel. Relevant information and budgeted annual income statements for each of the products follow. Relevant Information Skin Cream Bath Oil Color Gel Budgeted sales in units (a) 136,000 216,000 96,000 Expected sales price (b) $ 9 $ 7 $ 15 Variable costs per unit (c) $ 2 $ 4 $ 10 Income statements Sales revenue (a × b) $ 1,224,000 $ 1,512,000 $ 1,440,000 Variable costs (a × c) (272,000 ) (864,000 ) (960,000 ) Contribution margin 952,000 648,000 480,000 Fixed costs (777,000 ) (555,000 ) (160,000 ) Net income $ 175,000 $ 93,000 $ 320,000 Required: Determine the margin of safety as a percentage for each product. Prepare revised income statements for each product, assuming a 20 percent increase in the budgeted sales volume. For each product, determine the percentage change in net income that results from the 20 percent increase in sales. Assuming that management is pessimistic and risk averse, which product should the company add to its cosmetics line? Assuming that management is optimistic and risk aggressive, which product should the company add to its cosmetics line?

Solution

Skin Cream Bth Oil Color Gel Sales revenue 1224000 1512000 1440000 Less: Variable cost 272000 864000 960000 Contribution 952000 648000 480000 Less: Fixed cost 777000 555000 160000 Net Income 175000 93000 320000 CM Ratio 77.78% 42.86% 33.33% (Cnontribution/Sales*100) Margin of Safety in $ 225000 217000 960000 (Income/CM ratio Margin of Safety % 18.38% 14.35% 66.67% Req b: Revisedd Income Statement: Skin Cream Bth Oil Color Gel Sales revenue 1468800 1814400 1728000 Less: Variable cost 326400 1036800 1152000 Contribution 1142400 777600 576000 Less: Fixed cost 777000 555000 160000 Net Income 365400 222600 416000 Increase in Income 190400 129600 96000 % increase in Income 108.80% 139.35% 30% Req c: When the management is pessimistic, Product Color Gel is selected as it gives highest cushion as MOS is highest. Req d: when Management is optimistic, i.e. ready to take risk, it will concentrate on product having high operating leverage Which is highest in Bath Oil bath oil is selected.