Chapter 20: Q-23RQ (page 1120)
What is the margin of safety? What are the three ways it can be expressed?
Answer
Margin of safety is a cushion between profit and loss.
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What is a mixed cost? Give an example.
You have just begun your summer internship at Omni Instruments. The company supplies sterilized surgical instruments for physicians. To expand sales, Omni is considering paying a commission to its sales force. The controller, Matthew Barnhill, asks you to compute: (1) the new breakeven sales figure, and (2) the operating profit if sales increase 15% under the new sales commission plan. He thinks you can handle this task because you learned CVP analysis in your accounting class.
You spend the next day collecting information from the accounting records, performing the analysis, and writing a memo to explain the results. The company president is pleased with your memo. You report that the new sales commission plan will lead to a significant increase in operating income and only a small increase in breakeven sales.
The following week, you realize that you made an error in the CVP analysis. You overlooked the sales personnel’s $2,800 monthly salaries, and you did not include this fixed selling cost in your computations. You are not sure what to do. If you tell Matthew Barnhill of your mistake, he will have to tell the president. In this case, you are afraid Omni might not offer you permanent employment after your internship.
Requirements
1. How would your error affect breakeven sales and operating income under the proposed sales commission plan? Could this cause the president to reject the sales commission proposal?
2. Consider your ethical responsibilities. Is there a difference between (a) initially making an error and (b) subsequently failing to inform the controller?
3. Suppose you tell Matthew Barnhill of the error in your analysis. Why might the consequences not be as bad as you fear? Should Barnhill take any responsibility for your error? What could Barnhill have done differently?
4. After considering all the factors, should you inform Barnhill or simply keep quiet?
Using terminology Match the following terms with the correct definitions:
1. Costs that do not change in total over wide ranges of volume.
2. Technique that estimates profit or loss results when conditions change.
3. The sales level at which operating income is zero.
4. Drop in sales a company can absorb without incurring an operating loss.
5. Combination of products that make up total sales.
6. Net sales revenue minus variable costs.
7. Describes how a cost changes as volume changes.
8. Costs that change in total in direct proportion to changes in volume.
9. The band of volume where total fixed costs and variable cost per unit remain constant.
a. Breakeven point
b. Contribution margin
c. Cost behavior
d. Margin of safety
e. Relevant range
f. Sales mix
g. Fixed costs
h. Variable costs
i. Sensitivity analysis
What is the breakeven point?
Before you begin this assignment, review the Tying It All Together feature in the chapter.
Best Buy Co., Inc. is a leading provider of technology products. Customers can shop at more than 1,700 stores or online. The company is also known for its Geek Squad for technology services. Suppose Best Buy is considering a particular HDTV for a major sales item for Black Friday, the day after Thanksgiving, known as one of the busiest shopping days of the year. Assume the HDTV has a regular sales price of \(900, a cost of \)500, and a Black Friday proposed discounted sales price of \(650. Best Buy’s 2015 Annual Report states that failure to manage costs could have a material adverse effect on its profitability and that certain elements in its cost structure are largely fixed in nature. Best Buy, like most companies, wishes to maintain price competitiveness while achieving acceptable levels of profitability. (Item 1A. Risk Factors.)
Requirements
1. Calculate the gross profit of the HDTV at the regular sales price and at the discounted sales price.
2. Assume that during the November/December holiday season last year, Best Buy sold an average of 150 of this particular HDTV per store. If the HDTVs are marked down to \)650, how many would each store have to sell this year to make the same total gross profit as last year?
3. Relative to Sales Revenue, what type of costs would Best Buy have that are fixed? What type of costs would be variable?
4. Because Best Buy stated that its cost structure is largely fixed in nature, what might be the impact on operating income if sales decreased? Does having a cost structure that is largely fixed in nature increase the financial risk to a company? Why or why not?
5. In the Tying It All Together feature in the chapter, we looked at the cost of advertising. Is advertising a fixed or variable cost? If the company has a small margin of safety, how would increasing advertising costs affect Best Buy’s operating income? What would be the effect of decreasing advertising costs?
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