1. How Is the Margin of Safety Computed, and What Does It Tell a Manager?

DISCUSSION QUESTONS

1. How is the margin of safety computed, and what does it tell a manager?

2. What is the contribution margin not realized, and how does computing it help a manager?

EXERCISE 2–1 Margin of Safety

Mower Manufacturing’s income statement for January 2003 is given below:

Sales (25,000 units x $25) $625,000

Less variable costs 450,000

Contribution margin $175,000

Less fixed costs 125,000

Profit $50,000

1.What is the company’s current margin of safety in both dollar and percentage terms?

2.The company is contemplating the purchase of new production equipment that would reduce variable costs per unit to $16. However, fixed costs would increase to $175,000 per month. Assuming sales of 26,000 units next month, prepare an income statement for both the current and the proposed production methods. Calculate margin of safety (in dollars and percentage) for the new production method.

EXERCISE 2–2 – Contribution Margin Not Realized

Wasteful Company produces and sells two products, A and Z. The average per-unit sales price is $10.50 and $22.10 for Product A and for Product Z, respectively. The variable costs per unit are $4.50 for Product A and $14.75 for Product Z. At current production levels, the company has unused capacity of 10,000 units of Product A and 25,000 units of Product Z. If the company can sell all the additional products it can make to a major retailer under that retailer’s brand name and at a price that is 20% under its average selling price, what is the contribution margin not realized for each product and in total?

PROBLEM 2–1 – Contribution Margin Not Realized

Mike’s Ice Cream Company produces and sells ice cream in three sizes: quart, half-gallon, and gallon. Relevant information for each of the sizes is as follows:

QuartHalf-GallonGallon

Average sales price$1.00$1.85$3.60

Less variable cost0.801.402.40

Unit contribution margin$0.20$0.45$1.20

Sales mix (% of sales)15%60%25%

Mike anticipates sales of $500,000 and fixed costs of $120,000 in 2003.

Required:

Assume that Mike has unused capacity at current production levels of 3,000 quarts, 12,000 half-gallons, and 5,000 gallons. If the company can sell all additional units to a large grocery store at a price that is 10% below its normal selling price, what is the total contribution margin not realized?

PROBLEM 2–2 – Margin of Safety

The following summary data are provided for Basalt Mercantile Corporation and Sunshine Service, Inc. (000’s omitted):

BasaltSunshine

Mercantile Corp.Service Inc.

Sales revenue (100,000 units) $520 (200,000 units) $1,050

Less variable costs 260 315

Contribution margin $260 $735

Less fixed costs 100 300

Income $160 $435

Required:

Calculate the margin of safety for Basalt and Sunshine in both dollars and percentages.