Question

CLP is planning to go into the designer jeans business. They project the following costs for the first year of operation:

• Rental payments                 $1,500 per month
• Direct Labor              $9.50 per hour
• Raw Materials           $6 per pair of jeans
• Overhead                           $975 per week
• Interest on Capital               $1,350 per month

It takes 20 minutes of direct labor to assemble a pair of pants, and CLP sells his designer jeans for $39.50 a pair.

• How many pairs of jeans must be sold to break even the first year? (assume a 50 week year)
• If profits total $38,500 for the first year, what is CLP’s safety margin?
• After a successful first year, CLP foresees a decline in designer jeans demand as a result of a weakening economy. If CLP wants a break-even point of 2,300 units, how much of a reduction in fixed costs would be necessary?
• What three alternative methods are available for reducing the break-even point? Using each of these methods, what adjustments must be made to meet CLP’s break-even point of 2,300 units?
• Considering the uncertain demand conditions faced by CLP, which of the three methods for reducing break-even points is the most appropriate? Why?

Answer 1

1)

direct labour per unit = $9.5 per hour with 20 minutes taken for each unit

thus in one hour i.e 60 minutes , 3 units are made

direct labour per unit = 9.5/3 = 3.167

variable cost per unit = raw materials per unit + direct labour per unit

variable cost per unit = 6 + 3.167 = 9.167

contribution per unit = selling price per unit - variable cost per unit

contribution per unit = 39.5 - 9.167 = 30.333

fixed costs per year for CLP = Rental payments + Overhead + Interest on Capital

fixed costs per year for CLP = 1500 x 12 + 975 x 50 + 1350 x 12

fixed costs per year for CLP = 18000 + 48750 + 16200 = 82950

breakeven point = fixed costs / contribution per unit

breakeven point = 82950 / 30.333

breakeven point = 2374.6 = 2375 jeans (rounded off)

2)

if profit = 38500

contribution = profit + fixed costs

contribution = 38500 + 82950 = 121450

contribution per unit = 30.333

thus units sold = 121450/30.333 = 4003.8 = 4004 units (rounded off)

margin of safety = (current sales - breakeven sales) / current sales

margin of safety = (4004 - 2375)/4004

margin of safety = 1629/4004 =40.68%

3)

if breakeven point = 2300

2300 = fixed costs / 30.333

fixed costs = 69766.67

initial fixed costs = 82950

reduction in fixed costs = 82950 - 69766.67 = 13183.33

4)

three alternative methods are

a)

reducing fixed costs as shown above

b)

reducing variable costs

if breakeven point = 2300

2300 = 82950 / contribution per unit

contribution per unit = 82950/2300 = 36.07

selling price = 39.5

variable costs per unit = 39.5 - 36.07 = 3.43

current variable cost per unit = 9.167

reduction in variable cost = 9.167 - 3.43 = 5.737

c)

increasing selling price

if breakeven point = 2300

2300 = 82950 / contribution per unit

contribution per unit = 82950/2300 = 36.07

variable costs per unit = 9.167

selling price per unit = 36.07 + 9.167 = 45.237

increase in selling price = 45.237 - 39.5 = 5.737

5)

The most feasible option for reducing breakeven costs is to reduce the variable cost per unit

increasing selling price will not be feasible as there is uncertain demand already, increase in price can reduce demand even more

fixed costs cannot be reduced as interest rent cannot be changed

variable cost however can be reduced by laying off employees and purchasing materials for a lower price considering the bad state of the economy

Thanks, if you have any doubts please leave a comment and let me know