AMF Cession 5- Suggested Answer

A1. Fixed costs are the ones which are not affected by changes in the level of the business activities, over a defined period of time, whereas variables cost do change with the level of the business activities over time.

A2: CVP formula

Cost function = [(P-VC) Q-TFC] = IBT (Income before tax)

Net Income = (Total Revenue-Total Cost)[1-t]

Cost Function

Net Income = (Total Revenue-Total Variable Costs-Total Fixed Costs)[1-t]

Given that miscellaneous office costs are mixed costs then using the two-point method we can derive the cost function:

We assume the cost function is y =a +bx

Where a is the cost of 20X,1 which is 40,000, X2 represents Year 20X2 and X1 represents Year 20X1,

b= Y2-Y1 =45,000-40,000 =5,000 =5000 X2-X1 =2-1 = 1

Therefore Y=40,000+5000X

For Year 20X3, the miscellaneous cost will be 50,000.

A3.Using the Profit function

Net Profit = Total Revenue –Total Costs)[1-t], where t is the tax rate here given as 20% which is 0.2.

Therefore for Year 20X2, we have calculated in the below workings and found out that Total cost is 2,003,000 now that the company must achieve a Net income after tax of 500,000, we simply substitute our figures to the above profit function for Year 20X2

500,000 = (Total Revenue-2,003,000) [1-0.2]

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=625,000 = (Total Revenue -2,003,000)

Therefore Total Revenue = (2,003,000 +625,000) = 2,628,000

A3: Workings

PAUKOVICH CONSULTINGINCOME STATEMENTS

20x2 20x1

Revenues 2,500,000.00 2,000,000.00 less: Variable Costs;Consultants salaries (290,000.00) (270,000.00) Other General & Admin Salaries (135,000.00) (130,000.00) Payroll taxes (252,000.00) (231,000.00) Survey labour, Printing (900,000.00) (700,000.00) Miscellaneeus offi ce costs (45,000.00) (1,622,000.00) (41,000.00) (1,372,000.00) Contribution Margin 878,000.00 628,000.00 Contribution Margin Ratio 0.35 0.31 Less: Fixed Costs;President's Salary (150,000.00) (150,000.00) Rent, heat & lights (51,000.00) (50,000.00) Sales Commission (180,000.00) (381,000.00) (200,000.00) (400,000.00) Income before tax (EBIT) 497,000.00 228,000.00 less Income tax expenses @20% (99,400.00) (45,800.00) Net Income after tax 397,600.00 182,200.00

Total Variable Costs 1,622,000.00 1,372,000.00 Total Fixed Costs 381,000.00 400,000.00 Total Costs 2,003,000.00 1,772,000.00

YEARS

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A4: Degree of Operating Leverage

Managers decide how to structure the cost function for their organizations.

Often, potential

trade-offs are made between fixed and variable costs. For example, a

company could purchase

a vehicle (a fixed cost) or it could lease a vehicle under a contract that

charges a rate per

mile driven (a variable cost). One of the major disadvantages of fixed costs

is that they may be

difficult to reduce quickly if activity levels fail to meet expectations, thereby

increasing the

organization’s risk of incurring losses.

The degree of operating leverage is the extent to which the cost function

is made up

of fixed costs. Organizations with high operating leverage incur more risk of

loss when sales

decline. Conversely, when operating leverage is high an increase in sales

(once fixed costs

are covered) contributes quickly to profit. The formula for operating leverage

can be written

in terms of either contribution margin or fixed costs, as shown here.7

_ _ _

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Degree of operating leverage in terms of fixed costs_ _1

Managers use the degree of operating leverage to gauge the risk associated

with their cost

function and to explicitly calculate the sensitivity of profits to changes in

sales (units or

revenues):

Substituting to the above equation for Year 20X2 is 878,000/497,000 =1.76.

The greater the Degree of Operating Leverage ratio, the greater TFC and the

greater operating risk (potential profit fluctuation).

A5. Margin of Safety =Expected Sales – Break Even Sales.

Break Even Sales is where (Total Sales-Variable costs –Fixed Costs) = Income

before taxes.

For Year 20X2 is Contribution Margin is 0.35, as Selling price is unknown, we

assume S= Break Even Sales( by setting EBT =0)

Therefore (S-0.65S-381,000) = 0

= 0.35S – 381,000 = 0, hence S =381,000/0.35 = 1,088,571

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Therefore Margin of Safety = Actual Sales revenue for 20X2= {(2,500,000) -

1,088,571} =1,411,429 .

= 1,411,429/2,500,000 = 0.565.

Margin of Safety:

The Margin of Safety is the excess of projected (or actual ) sales over the

break-even sales level. This tells managers the margin between current

sales and the breakeven point. In a sense, margin of safety indicates the

risk of losing money that a company faces, that is the amount by which sales

can fall before the company is in the loss area.

For example for Paukovich Consulting Company: Holding all other variables

constant, if current sales for Year 20X2 is 2,500,000, dropped by 56.5%, the

company’s profit would be reduced to zero (Break-even)

It is often viewed as “cushion of loss”. The larger the ratio, the safer the

situation is since there is less risk of reaching the break-even point.

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