Arrow products typically earn a contribution margin ratio of 25 percent and has

Question

Arrow products typically earn a contribution margin ratio of 25 percent and has current fixed costs of $80,000. Arrow's general manager is considering spending an additional $20,000 to do one of the following: 1. Start a new ad campaign that is expected to increase sales revenue by 5 percent. 2. License a new computerized ordering system that is expected to increase Arrow's contribution margin ratio to 30 percent. Sales revenue for the coming year was initially forecast to equal $1,200,000 (that is, without implementing either of the above options.) a. For each option, how much will projected operating income increase or decrease relative to initial predictions? b. By what percentage would sales revenue need to increase to make the ad campaign as attractive as the ordering system?

Explanation / Answer

contribution margin ratio = 25% current fixed costs = 80,000 1. ad campaign would increase revenue by 5% 2. new ordering system increase cmr to 30% sales revenue 1,200,000 a. current income: 1,200,000*.25 - 80,000 = 220,000 ad campaign: 1,200,000*1.05*.25 - 100,000 = 215,000, income would decrease by 5,000 ordering system: 1,200,000*.30 - 100,000 = 260,000, income would increase by 45,000 b. 1,200,000*x*.25 - 100,000 = 260,000 300,000x = 360,000 x = 360,000/300,000 = 1.2 sales revenue would have to increase by .2 or 20%

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