C) A firm with annual sales of €60 million pays out 50% of its sales as cost of
ID: 348764 • Letter: C
Question
C) A firm with annual sales of €60 million pays out 50% of its sales as cost of goods sold. Overhead amounts to 10 million. Labour and salaries are 14 million. Thus, a profit of 6 million is realsed. Assets are €20 million, of which 20% are in inventories. a) If the firm can (1) increase sales volume, (2) raise price, (3) reduce labour and salaries, (4) decrease overhead, or (5) reduce the costs of goods sold, how much change (in percent) in each category would be required to increase the profit to 8 million? b) If prices of purchased materials (ie, costs of goods sold) can be reduced by 6% percent, what return on assets can be realised? How does this compare with the current ROA?Explanation / Answer
Annual revenue or sales of firm = 60 million euro
Cost of goods sold = 50% of annual sales = 30 million euros
Overhead costs = 10 million euros
Labour and salaries cost = 14 million euros
Total costs = 54 million euros
Total profit = 60-54 = 6 million euros
Total assets of the company = 20 million euros
Current return on assets = Net income / Total assets = 6/20 = 30%
Ans a) To increase the profit to 8 million euros, we require an additional 2 million euros of profit
This profit can arise from the 5 given situations. Thus to increase profit by 2 million, we need to decrease the expenditure or increase revenue by 2 million from these 5 categories one by one.
1) By increasing sales volume, we can get an additional 2 million euros
As the costs are 50% of the total revenue generated, to attain a profit of 2 million euros, we need to generate sales of 4 million euros, so that the costs for those 4 million worth of sales is
= 50% of 4
= 2 million euros
Thus percentage change would be = [(Final value - Initial value)/ Initial value] * 100
=[(64-60)/60] * 100
= 400/60
= 6.666 %
2) By increasing prices, we can get an additional 2 million euros with the same sales volume
Thus percentage change would be = [(Final value - Initial value)/ Initial value] * 100
=[(32-30)/30] * 100
= 100/15
= 6.666 %
3) By reducing labour costs and salaries, we can get an additional 2 million euros with the same sales volume
Thus percentage change would be = [(Final value - Initial value)/ Initial value] * 100
=[(12-14)/14] * 100
= 200/14
= 14.285 %
4) By decreasing overhead costs, we can get an additional 2 million euros with the same sales volume
Thus percentage change would be = [(Final value - Initial value)/ Initial value] * 100
=[(8-10)/10] * 100
= 200/10
= 20 %
5) By reducing the costs of goods sold, we can get an additional 2 million euros with the same sales volume
Thus percentage change would be = [(Final value - Initial value)/ Initial value] * 100
=[(28-30)/30] * 100
= 100/15
= 6.666 %
Ans b) Total costs of goods = 30 million euros
If this price is reduced by 6 %, then new costs would be = 30 ( 1 - 0.06)
= 28.2 million euros
This reduction in costs would lead to an extra profit of 1.8 million euros
Thus new return on assets would be = (6 + 1.8)/ 20
=7.8/20
= 39%
The new ROA is greater by 9 % as compared to the current ROA.
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