Sam Yu, the president of Centech Computer Services, needs your help. He wonders

Question

Sam Yu, the president of Centech Computer Services, needs your help. He wonders about the potential effects on the firm's net income if he changes the service rate that the firm charges its customers. The following basic data pertain to fiscal year 2009.

Standard rate and variable costs:
service rate per hour $83.00
labor 40.00
overhead 7.10
general selling & administrative 4.40

Expected fixed costs:
facility repair $500,000.00
general, selling, & administrative 130,000.00

Required

a. Prepare the pro forma income statement that would appear in the master budget if the firm expects to provide 27,000 hours of services in 2009.

b. A marketing consultant suggests to Mr. Yu that the service rate may affect the number of service hours that the firm can achieve. According to the consultant's analysis, if Centech charges customers $78 per hour, the firm can achieve 33,000 hours of services. Prepare a flexible budget using the consultant's assumption.

c. The same consultant also suggests that if the firm raises its rate to $88 per hour, the number of service hours will decline to 22,000. Prepare a flexible budget using the new assumption.

d. Evaluate the three possible outcomes you determined in Requirements a, b, and c and recommend a pricing stategy.

Explanation / Answer

a. Prepare the pro forma income statement that would appear in the master budget if the firm expects to provide 27,000 hours of services in 2009.

                    Proforma Income Statement

Sales Revenue  27,000 hrs. x $83                 $2,241,000
Less: Variable Costs
         Labor 27,000 hrs. x $40   $1,080,000
         Overhead 27K x $7.10          $191,700
         General S&A 27K x $4.40      $118,800 $1,390,500
Gross Profit                                                     $850,500
Less : Fixed Costs
          Facility Repair       $500,000
          General S&A          $130,000                  $630,000
Net Income                                                     $220,500
                                                                   =========
b. A marketing consultant suggests to Mr. Yu that the service rate may affect the number of service hours that the firm can achieve. According to the consultant's analysis, if Centech charges customers $78 per hour, the firm can achieve 33,000 hours of services. Prepare a flexible budget using the consultant's assumption.
                                                      -------Hours--------                  
                                             27,000        30,000        33,000
Sales Revenue    @$78       $2,106,000   $2,340,000     $2,574,000
Less : Variable costs
          Labor     @$40        $1,080,000    $1,200,000    $1,320,000
          Overheads @$7.10     $191,700       $213,000      $234,300
          General S&A $4.40     $118,800       $132,000      $145,200
Total Variable costs           $1,390,500    $1,545,000   $1,699,500
                                      ==================================
Gross profit                        $715,500       $795,000      $874,500
Less: Fixed Costs
        Facility Repair            $500,000       $500,000      $500,000
        General S & A             $130,000       $130,000      $130,000
Total Fixed Costs              $630,000        $630,000      $630,000
Net Income                          $85,500        $165,000     $244,500
                                       ================================
c. The same consultant also suggests that if the firm raises its rate to $88 per hour, the number of service hours will decline to 22,000. Prepare a flexible budget using the new assumption.

                                                      -------Hours--------                  
                                             18,000        20,000        22,000
Sales Revenue    @$88      $1,584,000   $1,760,000     $1,936,000
Less : Variable costs
          Labor     @$40           $720,000       $800,000     $880,000
          Overheads @$7.10    $127,800        $142,000      $156,200
          General S&A $4.40      $79,200        $88,000        $96,800  
Total Variable costs             $927,000    $1,030,000   $1,133,000
                                      ==================================
Gross profit                        $657,000       $730,000      $803,000
Less: Fixed Costs
        Facility Repair            $500,000       $500,000      $500,000
        General S & A             $130,000       $130,000      $130,000
Total Fixed Costs              $630,000        $630,000      $630,000
Net Income                          $27,000       $100,000     $173,000
                                       ================================
d. Evaluate the three possible outcomes you determined in Requirements a, b, and c and recommend a pricing stategy.

Possibilities
a. 27,000 hours      Net Income    $220,500
b. 33,000 hours      Net Income    $244,500
c. 22,000 hours      Net Income    $173,000

The best option is to reduce price to $78 per hour with the assumption of total 33,000 service hours against existing 27,000 hours at $83 per hour. This will increase the existing profit by $24,000 ($244,500 - $220,500)


                                               

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