Question

Eagle Company makes the MusicFinder, a sophisticated satellite radio. Eagle has experienced a steady growth in sales for the past five years. However, Ms. Luray, Eagle's CEO, believes that to maintain the company's present growth will require an aggressive advertising campaign next year. To prepare for the campaign, the company's accountant, Mr. Bednarik, has prepared and presented to Ms. Luray the following data for the current year, year 1:

Variable costs:
Direct labor (per unit)	$	80
Direct materials (per unit)		36
Variable overhead (per unit)		15
Total variable costs (per unit)	$	131
Fixed costs (annual):
Manufacturing	$	392,000
Selling		293,000
Administrative		781,000
Total fixed costs (annual)	$	1,466,000
Selling price (per unit)		415
Expected sales revenues, year 1 (21,000 units)	$	8,715,000

Eagle has an income tax rate of 40 percent.

Ms. Luray has set the sales target for year 2 at a level of $10,790,000 (or 26,000 radios).

Required:

a. What is the projected after-tax operating profit for year 1?

b. What is the break-even point in units for year 1?

c. Ms. Luray believes that to attain the sales target (26,000 radios) will require additional selling expenses of $282,000 for advertising in year 2, with all other costs remaining constant. What will be the after-tax operating profit for year 2 if the firm spends the additional $282,000?

d. What will be the break-even point in sales dollars for year 2 if the firm spends the additional $282,000 for advertising?

e. If the firm spends the additional $282,000 for advertising in year 2, what is the sales level in dollars required to equal the year 1 after-tax operating profit?

f. At a sales level of 26,000 units, what is the maximum amount the firm can spend on advertising to earn an after-tax operating profit of $760,000?

Answer 1

(a)

Contribution per unit = Selling price - total variable cost

= $415 - $131 i.e. $284 per unit

Total Fixed cost (Year 1) = $1,466,000 (given)

Operating Profit Before taxes (Year 1) = (Units sold * Contribution per unit) - Total Fixed Cost

= (21,000 units @ $284 ) - $1,466,000

= $5,964.000 - $1,466,000

= $4,498,000

Operating Profit After taxes = Operating profit before taxes * (1 - tax rate)

= $4,498,000 * (1 - 0.40)

= $2,698,800

(b)

Break even point (in units) = Total fixed costs / Contribution per unit

= $1,466,000 / $284

= 5,161.97 i.e. 5,162 units

(c)

Before Tax operating Profit = (number of units sold * Contribution per unit) - Total Fixed cost (Year 1) - Additional Fixed cost

= (26,000 units @ $284) - $1,466,000 - $282,000

= $5,636,000

After tax operating profit = Operating profit before taxes * (1 - tax rate)

= $5,636,000 * (1 - 0.40)

= $3,381,600

(d)

Break even point (in dollars) = (Total fixed cost / Contribution per unit) * Selling price per unit

= [ ($1,466,000 + $282,000) / $284 ] * $415

= 6,154.9295 units * $415

= 6,155 units * $415 i.e. $2,554,325

(e)

After tax operating profit (Year 1) = After tax operating profit (Year 2)

i.e. Before tax operating profit (Year 1) = Before tax operating profit (Year 2) = $4,498,000

(Quantity sold (Year 2) * Contribution per unit) - Fixed cost (Year 2) = $4,498,000

(Quantity sold (Year 2) * Contribution per unit) - $1,748,000 = $4,498,000

(Quantity sold (Year 2) * $284) = $6,246,000

Quantity sold (Year 2) = $6,246,000 / $284

Quantity sold (Year 2) = 21,992.96 units i.e. 21,993 units

Sales Level in Dollars = Sales Quantity * Selling price

= 21,993 units @ $415

= $9,127,095

(f)

After tax operating profit = $760,000

Before tax operating profit = After tax operating profit / (1 - tax rate)

Before tax operating profit = $760,000 / (1 - 0.4)

Before tax operating profit = $1,266,667

Before tax operating profit = (Quantity sold * Contribution margin per unit) - Other fixed costs - Advertisement Cost

$1,266,667 = (26,000 units @ $284) - $1,466,000 - Advertisement cost

Advertisement cost = (26,000 units @ $284) - $1,266,667 - $1,466,000

Advertisement cost = $7,384,000 - $2,732,667

Advertisement cost = $4,651,333