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- 13 Marks
Question
Anima Ventures wants to start a new bakery at Bodwease in Ashanti Region. She plans to rent a storeroom for her operations under the following terms and conditions:
| Option 1 | Option 2 | |
|---|---|---|
| Fixed Rent Charge | GH¢5,000 | GH¢3,000 |
| Variable Rent | – | 10% of selling price of each loaf |
The following data are also relevant for her business:
- Selling Price: GH¢5.00
- Material Cost (Flour): GH¢0.80
- Material Cost (Margarine): GH¢0.70
- Labour Cost: GH¢0.50
Required:
i) Determine the break-even point in units under each option.
(2 marks)
ii) Calculate the degree of operating leverage (DOL) for the two options if 10,000 loaves of bread are to be sold in the current year.
(4 marks)
iii) What would be the expected operating income if sales increase by 25% next year?
(4 marks)
iv) Which of the two options would you recommend to Anima Ventures and why?
(3 marks)
Answer
i) Break-Even Point in Units:
- Option 1:
Contribution per unit = GH¢5.00 – (GH¢0.80 + GH¢0.70 + GH¢0.50) = GH¢3.00
Break-Even Point = Fixed Cost / Contribution per unit
= GH¢5,000 / GH¢3.00 = 1,667 loaves of bread - Option 2:
Contribution per unit = GH¢5.00 – (GH¢0.80 + GH¢0.70 + GH¢0.50 + 10% of GH¢5.00)
= GH¢5.00 – GH¢2.50 = GH¢2.50
Break-Even Point = Fixed Cost / Contribution per unit
= GH¢3,000 / GH¢2.50 = 1,200 loaves of bread
ii) Degree of Operating Leverage (DOL):
- Option 1:
Total Contribution for 10,000 units = 10,000 x GH¢3.00 = GH¢30,000
Operating Profit = GH¢30,000 – GH¢5,000 = GH¢25,000
DOL = Total Contribution / Operating Profit
= GH¢30,000 / GH¢25,000 = 1.20 - Option 2:
Total Contribution for 10,000 units = 10,000 x GH¢2.50 = GH¢25,000
Operating Profit = GH¢25,000 – GH¢3,000 = GH¢22,000
DOL = Total Contribution / Operating Profit
= GH¢25,000 / GH¢22,000 = 1.14
iii) Expected Operating Income if Sales Increase by 25%:
- Option 1:
Percentage change in Operating Income = DOL x % change in Sales
= 1.20 x 25% = 30.00%
Expected Operating Income = GH¢25,000 + (30.00% x GH¢25,000) = GH¢32,500 - Option 2:
Percentage change in Operating Income = DOL x % change in Sales
= 1.14 x 25% = 28.50%
Expected Operating Income = GH¢22,000 + (28.50% x GH¢22,000) = GH¢28,270
iv) Recommendation: Option 1 is recommended as it has a higher Degree of Operating Leverage (1.20 vs. 1.14), indicating higher returns for any given level of sales. Additionally, since the expected sales exceed the break-even point, Option 1 provides a greater opportunity for profit if sales increase beyond the expected levels.
- Topic: Cost-Volume-Profit (CVP) Analysis, Relevant Cost and Revenue
- Series: MAY 2016
- Uploader: Dotse