Question

Henna Co. produces and sells two products, T and O. It manufactures these products in separate factories and markets them through different channels. They have no shared costs. This year, the company sold 50,000 units of each product. Sales and costs for each product follow.

	Product T	Product O
Sales	\(2,000,000	\)2,000,000
Variable cost	1,600,000	250,000
Contribution margin	400,000	1,750,000
Fixed costs	125,000	1,475,000
Income before taxes	275,000	275,000
Income taxes (32% rate)	88,000	88,000
Net income	\(187,000	\)187,000

Required

1. Compute the break-even point in dollar sales for each product. (Round the answer to whole dollars.)

2. Assume that the company expects sales of each product to decline to 30,000 units next year with no change in unit selling price. Prepare forecasted financial results for next year following the format of the contribution margin income statement as just shown with columns for each of the two products (assume a 32% tax rate). Also, assume that any loss before taxes yields a 32% tax benefit.

3. Assume that the company expects sales of each product to increase to 60,000 units next year with no change in unit selling price. Prepare forecasted financial results for next year following the format of the contribution margin income statement shown with columns for each of the two products (assume a 32% tax rate).

Analysis Component

4. If sales greatly decrease, which product would experience a greater loss? Explain.

5. Describe some factors that might have created the different cost structures for these two products.

Short answer

1. Break-even sales:

Product T:$625,000

Product O:$1,658,714

2. Net income when 30,000 units are sold:

Product T: $78,200

Product O: ($289,000)

3. Net income when 60,000 units are sold:

Product T: $241,400

Product O: $425,000

4. Product O will incur a higher loss due to a decrease in sales volume.

5. Direct material, labor, and production facilities.

Step-by-step solution

Definition of Fixed Cost

Fixed cost is that cost that is not affected by the level of activity achieved by the business entity. Such cost remains fixed until the capacity is increased by capital expenditure.

Break-even point in dollar sales

Product	Contribution	/	Sales	=	Contribution margin ratio
T	$400,000	/	$2,000,000	=	0.20
O	$1,750,000	/	$2,000,000	=	0.875
Product	Fixed cost	/	Contribution margin ratio	=	Break-even sales in dollar
T	$125,000	/	0.20	=	$625,000
O	$1,475,000	/	0.875	=	$1,658,714

Forecasted income statement for 30,000 units

	Product T	Product O
Sales	$1,200,000	$1,200,000
Variable cost	960,000	150,000
Contribution margin (as per contribution margin ratio)	240,000	1,050,000
Fixed costs	125,000	1,475,000
Income before taxes	115,000	(425,000)
Income taxes (32% rate)	36,800	136,000
Net income	$78,200	($289,000)

Forecasted income statement for 60,000 units

	Product T	Product O
Sales	$2,400,000	$2,400,000
Variable cost	1,920,000	300,000
Contribution margin (as per contribution margin ratio)	480,000	2,100,000
Fixed costs	125,000	1,475,000
Income before taxes	355,000	625,000
Income taxes (32% rate)	113,600	200,000
Net income	$241,400	$425,000

Effect of decrease in sales

Product O will experience a higher loss due to a decrease in sales volume. It has a higher fixed cost that will not be covered by the contribution margin generated through lower sales.

Factors affecting the cost structure

1. Direct material and direct labor are used in the production of both products.
2. Expenses incurred in respect of the production facilities used for each product. Such as depreciation expenses on equipment and rent expenses for space used.