Arrow Products typically earns a contribution margin ratio of 25 percent and has

Question

Arrow Products typically earns a contribution margin ratio of 25 percent and has current fixed costs of $80,000. Arrow's general manager is considering spending an additional $20,000 to do one of the following 1. Start a new ad campaign that is expected to increase sales revenue by 5 percent. 2. License a new computerized ordering system that is expected to increase Arrow's contribution margin ratio to 30 percent. Sales revenue for the coining year was initially forecast to equal $1,200,000 (that is, without implementing either of the above options). a. For each option, how much will projected operating income increase or decrease relative to initial predictions? b. By what percentage would sates revenue need to increase to make the ad campaign as attractive as the ordering system?

Explanation / Answer

Variable Costs = Revenues x (1 – contribution margin ratio)

For the ad campaign to be as attractive as the ordering system it should generate $40000 as operating income with $20000 as the fixed costs and 25% contribution margin.

Let the additional revenues be X

Operating Income = Revenues – Variable Costs – Fixed Costs

$40000 = X – 0.75X – $20000

0.25X = $60000

X = 60000 / 0.25 = $240000

Verification

Operating Income = Revenues – Variable Costs – Fixed Costs

Revenue

Variable Costs

Fixed Costs

Operating Income

$1,440,000.00

$1,080,000.00

$100,000.00

$260,000.00

Percentage of additional revenues = 240000 / 1200000 = 20%

Forecast Revenue Variable Costs Fixed Costs Operating Income Change Type Initial $1,200,000.00 $900,000.00 $80,000.00 $220,000.00 Ad campaign $1,260,000.00 $945,000.00 $100,000.00 $215,000.00 $5,000.00 Decrease Ordering system $1,200,000.00 $840,000.00 $100,000.00 $260,000.00 $40,000.00 Increase

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