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R Ltd manufactures and sells a single product. The budgeted income statement contained in the master budget for the forthcoming year is as follows :
Sales Revenue (20,000 units) = £640,000
Variable materials cost = £ 190,000
Variable labour cost = £172,000
Variable overhead = £13,000
Fixed overhead = £155,000
Budgeted net profit = £110,000The directors wish to know what the budgeted profit will be if a higher quality material is used. This will increase material costs per unit by 10% but sales volume will be increased by 5%. There will be no change in the unit selling price.
Are the proposed changes worthwhile?
What is it you don’t understand in the published solution? Simply adjusting each line for the changes will give you the answer. 5% increase in volume is 1,000 units, so:
Sales Revenue (20,000 units) = £640,000 …. x 21,000/20,000 = 672,000
Variable materials cost = £ 190,000 …. x 21/20 x 110% = 219,450
Variable labour cost = £172,000 … x 21/20 …
Variable overhead = £13,000 … x 21/20 …
Fixed overhead = £155,000… is UNCHANGED
Budgeted net profit = £110,000 …. net result is £103,300 i.e. a reduction of £6,700 – so NOT worthwhile.Thank you very much for the answer Mrs Kim.
It says in th1 Study Manual the contribution from the increase in volume of 1000 units is not enough to cover the variable costs that is why the proposed changes are not worthwhile. This is what I am not able to understand. Can you show me the workings about how to find contribution for 1000 units and whether it covers the variable costs or not?
Thank You.
This sentence is simply an observation, deduced from the fact that total profit has fallen by £6,700. Since fixed costs are fixed means that total contribution has fallen (by this amount). Total contribution is total revenue less total variable costs, so if this has fallen but you know that revenue has increased (you can see by £32,000), total VC must have increased by more than £6,700. You don’t have to prove it, and it’s quite messy to do so.
Current selling price = £32 (640,000/20,000)
Current VC = £18.75 ((190,000 + 172,000 + 13,000)
So current contribution per unit = £13.25 (32 – 18.75)
New contribution per unit = £12.30 (£13.25 – 0.95 (i.e. the 10% increase in material cost))
Total contribution was £265,000 (20,000 x £13.25)
New total contribution will be £258,300 (21,000 x £12.30)
i.e. contribution fell by £6,700
You can’t consider just the 1,000 increase in volume of sales in isolation because the increase in material costs applies to ALL units – not just the increase.
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