Question

Cost Structures for Global Shippers Inc.

Management from Global Shippers Inc, an international shipping business, is in the process of assessing the choice between two different cost structures for the business. Option A has relatively higher variable costs per unit shipped but lower annual fixed costs, while Option B has the opposite—relatively lower variable costs in its cost structure but higher fixed costs. Assume that delivery selling prices per unit are constant. The table below contains critical information in making the decision:

Cost Information	Option A	Option B
Delivery price (revenue) per shipment	$100	$100
Variable cost per shipment delivered	$85	$60
Contribution Margin per unit	$15	$40
Fixed costs (annual)	$1,200,000	$4,500,000

Management wants you to write a professional report, answering the following questions:

Questions

1. What is the break-even point, in terms of volume (i.e., number of shipments per year), for Option A? Option B?

2. How many shipments would have to be made under Option A to produce operating income of $30,000 for an annual period?

3. How many shipments per year would have to be made under Option A to produce an operating margin equal to 9% of sales revenue?

4. How many shipments are required under Option B to produce net income of $180,000 per year, given a corporate tax rate of 40%?

5. Assume that for the coming year total fixed costs are expected to increase by 15% for each of the two options. What is the new break-even point, in terms of number of shipments, for each option? By what percentage did the break-even point change for each case? How do these figures compare to the percentage increase in budgeted fixed costs?

6. Assume an average income-tax rate of 20%. What volume (number of shipments) would be needed to generate net income of 5% of revenue for each option?

7. Which option do you think is the more profitable one for this business? Explain.

8. Which option do you consider to be more risky to the business? Explain (calculate degree of operating leverage to help answer this question).

Answer 1

SOLUTION:

	Option A ($)	Option B ($)
Delivery Price per shipment	100	100
Less: Variable Cost per shipment	85	60
Contribution per shipment	15	40
Fixed Cost (Annual)	1,200,000	4,500,000

BREAKEVEN POINT IN TERMS OF VOLUME (NO. OF SHIPMENTS PER YEAR):

For Option A:

Breakeven Point = Fixed cost / contribution per shipment

= 1,200,000 / 15

= 80,000 shipments per year

For Option B:

Breakeven Point = Fixed cost / contribution per shipment

= 4,500,000 / 40

= 112,500 shipments per year

TO PRODUCE OPERATING INCOME OF $30,000 UNDER OPTION A, NO. OF SHIPMENTS TO MAKE:

Under option A:

Desired Profit = $ 30,000

Breakeven sales = fixed cost + desired profit / contribution per shipment

= 1,200,000 + 30,000 / 15

= 1,230,000 / 15

= 82,000 shipments per year

Hence 82,000 shipments has to be made to produce operating income of $ 30,000.

TO PRODUCE OPERATING MARGIN EQUAL TO 9% OF SALES REVENUE UNDER OPTION A, NO. OF SHIPMENTS TO MAKE:

Operating Profit = 9% of sales revenue

= 9% *100

= 9 per shipment

assume shipments to be made = x

x = 1,200,000 + 9x / 15

15x = 1,200,000 + 9x

15x - 9x = 1,200,000

6x = 1,200,000

x = 1,200,000 / 6

x = 200,000 shipemts per year

Hence 200,000 shipments has to be made to produce operating margin equal to 9% of sales revenue

How many shipments are required under Option B to produce net income of $180,000 per year, given a corporate tax rate of 40%?

It is assume that tax effect has been given to arrive the net income of $ 180,000

Breakeven sales = fixed cost + desired profit / contribution per shipment

= 4,500,000 + 180,000 / 40

= 4,680,000 / 40

= 117,000 shipments per year

Hence 117,000 shipments has to be made to produce net income of 180,000