The owner of a package delivery business is currently evaluating the choice betw

Question

The owner of a package delivery business is currently evaluating the choice between two different cost structures, based on how the delivery personnel are paid. One option (hereafter, “Alternative #1”) has relatively higher short-term fixed costs, while the other option (hereafter, “Alternative #2”) has the reverse—that is, relatively higher variable costs in its cost structure. (For simplicity in this example we hold the delivery cost per package, that is, the selling price per unit is constant. Selling price is independent of the cost-structure choice.) The following table contains pertinent information for creating the CVP model for each decision alternative:

Decision Inputs (Data) Cost Structure Alternative #1 Cost Structure Alternative #2 Delivery price (i.e., revenue) per package $60 $60 Variable cost per package delivered $48 $30 Contribution margin per unit $12 $30 Fixed costs (per year) $600,000 $3,000,000

Particulars

Alternative 1

Alternative 2

Delivery Price (i.e. revenue) per package

$60

$60

Variable cost per package delivered

$48

$30

Contribution margin per unit

$12

$30

Fixed costs (per year)

$600,000

$3,000,000

(7) Assume that for the coming year total fixed costs are expected to increase by 10% for each of the two alternatives. What is the new break-even point, in terms of number of deliveries, for each decision alternative? By what percentage did the break-even point change for each case? How do these figures compare to the percentage increase in budgeted fixed costs?

10) Which decision alternative do you think is the more profitable one for this business?

(11) Based on the original data, which decision alternative is more risky to the business? Explain. (Hint: Think about, and define in your answer, the notion of “operating leverage.”)

(12) Finally, in building your profit-planning (i.e., CVP) model, the analyst makes a number of important assumptions. List the primary assumptions that underlie a conventional CVP analysis, such as the ones you conducted above.

Particulars

Alternative 1

Alternative 2

Delivery Price (i.e. revenue) per package

$60

$60

Variable cost per package delivered

$48

$30

Contribution margin per unit

$12

$30

Fixed costs (per year)

$600,000

$3,000,000

Explanation / Answer

Solution.

(7)

Particulars

Alternative 1

Alternative 2

Delivery Price (i.e. revenue) per package

$60

$60

Variable cost per package delivered

$48

$30

Contribution margin per unit

$12

$30

Fixed costs (per year)

$600,000

$3,000,000

100000 units
[$3000000 / $30]

*There has been same percentage increase in break even points as in Fixed costs.

(10) With the given set of information it is not possible to comment on the more profitable option for business. We would need Expected number of deliveries (sales) to comment on the same as both of the above alternatives would be profitable in different scenarios.

(11) The business having high operating leverage is generally considered to be more risky. A business is said to be highly leveraged when composition of fixed costs in the business is higher as compared to variable costs. It makes a business more vulnerable towards losses at the times of lower sales.

(12) Assumptions in CVP Analysis:

1) Total fixed costs do not change in the short-run.

2) Selling price remains constant.

3) Total variable costs are exactly proportionate to sales volume.

4) No major change in the size of inventory.

5) Each cost can be classified as fixed or variable.

Particulars

Alternative 1

Alternative 2

Delivery Price (i.e. revenue) per package

$60

$60

Variable cost per package delivered

$48

$30

Contribution margin per unit

$12

$30

Contribution margin ratio 20% 50%

Fixed costs (per year)

$600,000

$3,000,000

Existing Break Even point (Fixed Cost / Contribution per unit) 50000 units
[$600000 / $12]

100000 units
[$3000000 / $30]

New Increased Fixed Costs $660000 $3300000 New Break Even point (Fixed Cost / Contribution per unit) 55000 units
[$660000 / $12] 110000 units
[$3300000 / $30]

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