1. Fred M’mbololo Page 1
AMF Cession 5- Suggested Answer
A1. Fixed costs are the ones which are not affected by changes in the level of the
business activities, over a defined period of time, whereas variables cost do change
with the level of the business activities over time.
A2: CVP formula
Cost function = [(P-VC) Q-TFC] = IBT (Income before tax)
Net Income = (Total Revenue-Total Cost)[1-t]
Cost Function
Net Income = (Total Revenue-Total Variable Costs-Total Fixed Costs)[1-t]
Given that miscellaneous office costs are mixed costs then using the two-point method
we can derive the cost function:
We assume the cost function is y =a +bx
Where a is the cost of 20X,1 which is 40,000, X2 represents Year 20X2 and X1
represents Year 20X1,
b= Y2-Y1 =45,000-40,000 =5,000 =5000
X2-X1 =2-1 = 1
Therefore Y=40,000+5000X
For Year 20X3, the miscellaneous cost will be 50,000.
A3.Using the Profit function
Net Profit = Total Revenue –Total Costs)[1-t], where t is the tax rate here given as 20%
which is 0.2.
Therefore for Year 20X2, we have calculated in the below workings and found out that
Total cost is 2,003,000 now that the company must achieve a Net income after tax of
500,000, we simply substitute our figures to the above profit function for Year 20X2
500,000 = (Total Revenue-2,003,000) [1-0.2]
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=625,000 = (Total Revenue -2,003,000)
Therefore Total Revenue = (2,003,000 +625,000) = 2,628,000
A3: Workings
PAUKOVICH CONSULTING
INCOME STATEMENTS
20x2 20x1
Revenues 2,500,000.00 2,000,000.00
less: Variable Costs;
Consultants salaries (290,000.00) (270,000.00)
Other General & Admin Salaries (135,000.00) (130,000.00)
Payroll taxes (252,000.00) (231,000.00)
Survey labour, Printing (900,000.00) (700,000.00)
Miscellaneeus office costs (45,000.00) (1,622,000.00) (41,000.00) (1,372,000.00)
Contribution Margin 878,000.00 628,000.00
Contribution Margin Ratio 0.35 0.31
Less: Fixed Costs;
President's Salary (150,000.00) (150,000.00)
Rent, heat & lights (51,000.00) (50,000.00)
Sales Commission (180,000.00) (381,000.00) (200,000.00) (400,000.00)
Income before tax (EBIT) 497,000.00 228,000.00
less Income tax expenses @20% (99,400.00) (45,800.00)
Net Income after tax 397,600.00 182,200.00
Total Variable Costs 1,622,000.00 1,372,000.00
Total Fixed Costs 381,000.00 400,000.00
Total Costs 2,003,000.00 1,772,000.00
YEARS
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A4: Degree of Operating Leverage
Managers decide how to structure the cost function for their organizations. Often, potential
trade-offs are made between fixed and variable costs. For example, a company could purchase
a vehicle (a fixed cost) or it could lease a vehicle under a contract that charges a rate per
mile driven (a variable cost). One of the major disadvantages of fixed costs is that they may be
difficult to reduce quickly if activity levels fail to meet expectations, thereby increasing the
organization’s risk of incurring losses.
The degree of operating leverage is the extent to which the cost function is made up
of fixed costs. Organizations with high operating leverage incur more risk of loss when sales
decline. Conversely, when operating leverage is high an increase in sales (once fixed costs
are covered) contributes quickly to profit. The formula for operating leverage can be written
in terms of either contribution margin or fixed costs, as shown here.7
_ _ _
Degree of operating leverage in terms of fixed costs_ _1
Managers use the degree of operating leverage to gauge the risk associated with their cost
function and to explicitly calculate the sensitivity of profits to changes in sales (units or
revenues):
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Substituting to the above equation for Year 20X2 is 878,000/497,000 =1.76.
The greater the Degree of Operating Leverage ratio, the greater TFC and the greater operating
risk (potential profit fluctuation).
A5. Margin of Safety =Expected Sales – Break Even Sales.
Break Even Sales is where (Total Sales-Variable costs –Fixed Costs) = Income before taxes.
For Year 20X2 is Contribution Margin is 0.35, as Selling price is unknown, we assume S= Break
Even Sales( by setting EBT =0)
Therefore (S-0.65S-381,000) = 0
= 0.35S – 381,000 = 0, hence S =381,000/0.35 = 1,088,571
Therefore Margin of Safety = Actual Sales revenue for 20X2= {(2,500,000) -1,088,571}
=1,411,429 .
= 1,411,429/2,500,000 = 0.565.
Margin of Safety:
The Margin of Safety is the excess of projected (or actual ) sales over the break-even sales level.
This tells managers the margin between current sales and the breakeven point. In a sense,
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margin of safety indicates the risk of losing money that a company faces, that is the amount by
which sales can fall before the company is in the loss area.
For example for Paukovich Consulting Company: Holding all other variables constant, if current
sales for Year 20X2 is 2,500,000, dropped by 56.5%, the company’s profit would be reduced to
zero (Break-even)
It is often viewed as “cushion of loss”. The larger the ratio, the safer the situation is since there
is less risk of reaching the break-even point.
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