Early versions of cellular phones could do one thing—make and receive voice phon

Question

Early versions of cellular phones could do one thing—make and receive voice phone calls. Later versions were developed that could send and receive text messages, but due to their typing inter- face, performing this task was cumbersome. Then a company named Research in Motion (RIM) brought its BlackBerry phone to the market with an integrated keyboard that made typing text much easier. The BlackBerry became the phone of choice for users who wanted to send and receive e-mail messages via their cell phone, and its success soared. Unfortunately for RIM, Apple Inc. began selling the iPhone to the world in June of 2007. The iPhone was not only capable of dealing with e-mail messages efficiently, but it also allowed users to search the Internet using a popular touchscreen interface. The popularity of RIM’s BlackBerry began to decline. RIM’s sales declined 14 percent in its 2012 fiscal year compared to its sales in 2011, but its operating earnings declined 32 percent.

Required
Write a memorandum that explains how a 14 percent decline in sales could cause a 32 percent decline in profits. Your memo should address the following:
a.   An identification of the accounting concept involved.

b.   A discussion of how various major types of costs incurred by RIM were likely affected by the
decline in its sales.

c.   The effect of the decline in sales on RIM’s margin of safety.

Explanation / Answer

a. The accounting concept involved is the Cost-Volume-Profit analysis. When the sales change , the variable costs assocaited with the sales also change proportionaltely. However, the Fixed cost remain unchanged over a range of activity. Therefore the increase or decrease in operating margin happens more drastically than % change in sales.

b. If we consider the RIM case, the 14% decrease in sales definitely has been accompanied by reduction of variable costs like direct materials, direct labor and variable overheads to the same extent. Therefore contribution margin will reduce by 14 % amount wise. However, the fixed costs like fixed rents, insurances, fixed parts of salaries, depreciations, fixed dealership and marketing expenditures, research & development costs, interest on long term loans etc will remain the same . So the operating margin will get a bigger hit due to the same amount of fixed operating expendtures as it was before the sales decline. Therefore the opertaing margin will reduce much more than sales and contribution margin reduction of 14%. It appears that RIM has quite a huge amount of fixed cost component . so the Net operating income reduced by 32%.

c. The fixed cost for RIM remains unchanges even after sales reduction. So the break even sales remains the same. As the Actual sales drops by 14% , the Margin of safety will also drop by around 14% if the varoable cost to sales % remain the same.

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