Zachary Company is considering the addition of a new product to its cosmetics li
ID: 2609681 • Letter: Z
Question
Zachary Company is considering the addition of a new product to its cosmetics line. The company has three distinctly different options: a skin cream, a bath oil, or a hair coloring gel. Relevant information and budgeted annual income statements for each of the products follow.
Required:
Determine the margin of safety as a percentage for each product.
Prepare revised income statements for each product, assuming a 20 percent increase in the budgeted sales volume.
For each product, determine the percentage change in net income that results from the 20 percent increase in sales.
Which product has the highest operating leverage?
Assuming that management is pessimistic and risk averse, which product should the company add to its cosmetics line?
Assuming that management is optimistic and risk aggressive, which product should the company add to its cosmetics line?
Relevant Information Skin Cream Bath Oil Color Gel Budgeted sales in units (a) 140,000 220,000 100,000 Expected sales price (b) $ 7 $ 7 $ 15 Variable costs per unit (c) $ 2 $ 4 $ 11 Income statements Sales revenue (a × b) $ 980,000 $ 1,540,000 $ 1,500,000 Variable costs (a × c) (280,000 ) (880,000 ) (1,100,000 ) Contribution margin 700,000 660,000 400,000 Fixed costs (585,000 ) (585,000 ) (136,000 ) Net income $ 115,000 $ 75,000 $ 264,000Explanation / Answer
1. Margin of safety %:
Skin Cream
Bath Oil
Color Gel
a
Expected sales price
7
7
15
b
Variable cost per unit
2
4
11
c
Difference (a - b)
5
3
4
d
Fixed costs
585000
585000
136000
e
Margin of safety Units (d / c)
117000
195000
34000
f
Budgeted sales in units
1,40,000
2,20,000
1,00,000
g
Budgeted sales (f * a)
9,80,000
15,40,000
15,00,000
h
Margin of safety revenue (e * a)
8,19,000
13,65,000
5,10,000
i
Difference (g - h)
1,61,000
1,75,000
9,90,000
j
Margin of safety % (i / g *100)
16.43%
11.36%
66.00%
2. Revised income statement after 20% increase in sales:
Skin Cream
Bath Oil
Color Gel
a
Budgeted sales in units
1,40,000
2,20,000
1,00,000
b
New Budgeted Sales (a * 1.20)
168000
264000
120000
c
Expected sales price
7
7
15
d
Variable cost per unit
2
4
11
Income Statements
e
Sales Revenue (b * c)
1176000
1848000
1800000
f
Variable Costs (b * d)
336000
1056000
1320000
g
Contribution margin (e - f)
840000
792000
480000
h
Fixed costs
585000
585000
136000
i
Net Income (g - h)
255000
207000
344000
3. Percentage change in net income:
Skin Cream
Bath Oil
Color Gel
Net Income
115000
75000
264000
Net Income after 20% inc in sales
255000
207000
344000
Percentage change in net income
221.74%
276.00%
130.30%
4. Bath Oil has the highest operating leverage as shown below:
Skin Cream
Bath Oil
Color Gel
a
Contribution margin
700000
660000
400000
b
Fixed Costs
585000
585000
136000
c
Net Income (a - b)
115000
75000
264000
d
Operating leverage ( a / c)
6.09
8.80
1.52
5. Assuming that the management is pessimistic and risk averse, the company will add Color Gel to its cosmetics line as it has the highest margin of safety percentage (66%) or lowest margin of safety units (34000) due to very low fixed costs compared to others.
6. Assuming the management is optimistic and risk aggressive, the company will add will add Bath Oil to its cosmetics line as it has the highest operating leverage (8.8) and also the percentage increase in net income due to increase in sales (276%) is highest.
Skin Cream
Bath Oil
Color Gel
a
Expected sales price
7
7
15
b
Variable cost per unit
2
4
11
c
Difference (a - b)
5
3
4
d
Fixed costs
585000
585000
136000
e
Margin of safety Units (d / c)
117000
195000
34000
f
Budgeted sales in units
1,40,000
2,20,000
1,00,000
g
Budgeted sales (f * a)
9,80,000
15,40,000
15,00,000
h
Margin of safety revenue (e * a)
8,19,000
13,65,000
5,10,000
i
Difference (g - h)
1,61,000
1,75,000
9,90,000
j
Margin of safety % (i / g *100)
16.43%
11.36%
66.00%
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