EXERCISE 4-12 Target Profit and Break-Even Analysis; Margin of Safety; CM Ratio

Question

EXERCISE 4-12 Target Profit and Break-Even Analysis; Margin of Safety; CM Ratio
Menlo Company distributes a single product. The company's sales and expenses for last month follow:

Total Per Unit
Sales . $450,000 $30
Variable expenses . 180,000 12

Contribution margin . 270,000 $18
Fixed expenses . 216,000
Net operating income . $ 54,000


Required:
1. What is the monthly break-even point in units sold and in sales dollars?
2. Without resorting to computations, what is the total contribution margin at the break-even point?
3. How many units would have to be sold each month to earn a target profit of $90,000? Use the formula method. Verify your answer by preparing a contribution format income statement at the target sales level.
4. Refer to the original data. Compute the company's margin of safety in both dollar and percentage terms.
5. What is the company's CM ratio? If sales increase by $50,000 per month and there is no change in fixed expenses, by how much would you expect monthly net operating income to increase.

Explanation / Answer

1) Break-even point in units = Fixed costs / Unit contribution margin
                                        = $216,000 / (Unit Selling price - unit variable cost)
                                        = $216,000 / ($30 - $12)
                                        = $216,000 / $18
                                        = 12,000 units

Break-even sales in dollars = Fixed costs / Contribution margin ratio

But contribution margin ratio = Unit contribution margin / unit selling price
                                            = $18 / $30
                                           = 0.6 or 60%
Break-even sales in dollars = $216,000 / 0.6
                                      = $360,000

2) The contribution margin at the break-even point is $18

3) The contribution format income statement is prepared as

The net operating profit is given as $54,000

But we want to earn the target profit of $90,000

Finding the number of units for reaching the target profit

Projected Sales = (Fixed expenses + Profit)/ Contribution margin per unit
                    Q = ($216,000 + $90,000) / $18
                    Q = 17,000 units

4) Margin of safety = Actual or Budgeted sales - Break-even sales
                            = $450,000 - $360,000
                            = $90,000
Margin of safety in Percentage = Margin of safety in dollars / Budgeted sales
                                            = $90,000 / $450,000
                                            = 0.2 or 20%

5) Contribution margin ratio = Unit contribution margin / unit selling price
                                         = $18 / $30
                                         = 0.6 or 60%

If sales increase by $50,000 then the net operating income is computed as

Sales                              $500,000
(-) Variable expenses       $200,000
-----------------------------------------
Contribution margin         $300,000
(-) Fixed expenses           $216,000
-----------------------------------------
net operating profit         $84,000
-----------------------------------------

Therefore, the net operating profit increased by $30,000.

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