Question:
Margin of safety and operating leverage
Ireland Company is considering the addition of a new product to its cosmetics line. The company has three distinctly different options: a skin cream, a bath oil, or a hair coloring gel. Relevant information and budgeted annual income statements for each of the products follow.
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Relevant Information
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Skin Cream
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Bath Oil
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Color Gel
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Budgeted sales in units (a)
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71,000
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111,000
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39,000
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Expected sales price (b)
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$8
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$4
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$12
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Variable costs per unit (c)
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$5
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$2
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$7
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Income Statements
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Sales revenue (a 3 b)
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$568,000
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$444,000
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$468,000
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Variable costs (a 3 c)
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(355,000)
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(222,000)
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(273,000)
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Contribution margin
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213,000
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222,000
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195,000
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Fixed costs
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(153,000)
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(186,000)
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(155,000)
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Net income
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$60,000
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$36,000
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$40,000
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Required
a. Determine the margin of safety as a percentage for each product.
b. Prepare revised income statements for each product, assuming a 20 percent increase in the budgeted sales volume.
c. For each product, determine the percentage change in net income that results from the 20 percent increase in sales. Which product has the highest operating leverage?
d. Assuming that management is pessimistic and risk averse, which product should the company add to its cosmetic line? Explain your answer.
e. Assuming that management is optimistic and risk aggressive, which product should the company add to its cosmetics line? Explain your answer.