Case Study: Margin Of Safety

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Register to read the introduction… Margin of safety:

Present: Proposed:

Problem 5-29 (continued)
3. The major factor would be the sensitivity of the company’s operations to cyclical movements in the economy. Because the new equipment will increase the CM ratio, in years of strong economic activity, the company will be better off with the new equipment. However, in economic recession, the company will be worse off with the new equipment. The fixed costs of the new equipment will cause losses to be deeper and sustained more quickly than at present. Thus, management must decide whether the potential for greater profits in good years is worth the risk of deeper losses in bad years.

4. No information is given in the problem concerning the new variable expenses or the new contribution margin ratio. Both of these items must be determined before the new break-even point can be computed. The computations are:

New variable expenses:

Profit | = (Sales − Variable expenses) − Fixed expenses | $54,000** | = ($585,000* − Variable expenses) − $180,000 | Variable expenses | = $585,000 − $180,000 − $54,000 | | = $351,000 |

*New level of sales: $450,000 × 1.30 = $585,000 | **New level of net operating income: $45,000 × 1.2 = $54,000
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The overall break-even sales can be determined using the CM ratio.

| | Velcro | Metal | Nylon | Total | | Sales | $165,000 | $300,000 | $340,000 | $805,000 | | Variable expenses | 125,000 | 140,000 | 100,000 | 365,000 | | Contribution margin | $ 40,000 | $160,000 | $240,000 | 440,000 | | Fixed expenses | | | | 400,000 | | Net operating income | | | | $ 40,000 |

2. The issue is what to do with the common fixed cost when computing the break-evens for the individual products. The correct approach is to ignore the common fixed costs. If the common fixed costs are included in the computations, the break-even points will be overstated for individual products and managers may drop products that in fact are profitable.

a. The break-even points for each product can be computed using the contribution margin approach as follows:

| | Velcro | Metal | Nylon | | Unit selling price | $1.65 | $1.50 | $0.85 | | Variable cost per unit | 1.25 | 0.70 | 0.25 | | Unit contribution margin (a) | $0.40 | $0.80 | $0.60 | | Product fixed expenses (b) | $20,000 | $80,000 | $60,000 | | Unit sales to break even (b) ÷ (a) | 50,000 | 100,000 | 100,000

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