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1. Decide on a selling price and a sales volume for your first year of trading and then construct a marginal costing statement using this data. Set your variable cost at 25% of your selling price and your net profit at 20% of your total sales. Present your statement in a ‘per unit’ and ‘total year’ format.

## Base Case Scenario

It is important to provide the appropriate assumptions at the beginning to ensure that the students are aware of these to properly appraise the marginal costing statements under different underlying variable. In order to evaluate the impact of changes in underlying variables on profit and other important parameters of an organization the base case is assumed below.

 Base case scenario (Normal circumstances) Particulars Amount (?) Selling price per unit of finished goods 10 Variable cost per unit of finished goods 2.5 Fixed costs 660,000 Normal sales units 120,000 Net profit 240,000

Assuming that the above is the base scenario all the calculations and scenario analysis shall be made to evaluate the impact of changes in underlying variables on the amount of profit and other important elements of marginal costing statement of the above organization.

Using the base case scenario as provided in the table above the marginal costing statement of the organization in per unit and total year format is prepared and presented below.

 Particulars Per unit Total year Sales (120000 x 10) 10.00 1,200,000.00 Less: Variable costs (120000 x 2.5) 2.50 300,000.00 Contributions 7.50 900,000.00 Less: Fixed costs 5.50 660,000.00 Per unit fixed costs: (660000 / 120000) Net profit 2.00 240,000.00

Preparation and presentation of marginal costing statements under different scenario are provided below.

Part a:

When the selling price will increase by 15% from the base selling price of ?10.00 per unit the marginal costing statement per unit and total year would look like this.

 Particulars Per unit Total year Sales (120000 x 11.50) 11.50 1,380,000.00 Less: Variable costs (120000 x 2.5) 2.50 300,000.00 Contributions 9.00 1,080,000.00 Less: Fixed costs 5.50 660,000.00 Per unit: (660000 / 120000) Net profit 3.50 420,000.00

Note: It has been assumed that only the sales price have increased and other underlying variables have remained same, i.e. the variable cost per unit has remained at ?2.50 per unit and fixed costs have remained constant at ?660,000. It has been assumed that except the particular change no other changes have taken place in the underlying variables (Sofat and Hiro, 2015).

Part b:

Marginal costing statement of the organization if the original selling price reduces by 15% will be as following.

 Particulars Per unit Total year Sales (120000 x 8.50) 8.50 1,020,000.00 Less: Variable costs (120000 x 2.5) 2.50 300,000.00 Contributions 6.00 720,000.00 Less: Fixed costs 5.50 660,000.00 Per unit: (660000 / 120000) Net profit 0.50 60,000.00

Note: Again it is expected that the variable cost per unit and total fixed costs would remain unaffected due to the reduction in selling price per unit (Renz, 2016).

Part c:

The marginal costing statement of the organization if the variable costs reduces to 20% of the original selling price is presented below.

 Particulars Per unit Total year Sales (120000 x 10) 10.00 1,200,000.00 Less: Variable costs (120000 x 2) 2.00 240,000.00 Contributions 8.00 960,000.00 Less: Fixed costs 5.50 660,000.00 Per unit: (660000 / 120000) Net profit 2.50 300,000.00

Note: No changes in other underlying assumptions except reduction in variable costs to 20% of original selling price (Karadag, 2015).

The marginal costing statement of the organization will be as following if the variable costs of each unit increases to 30% of original selling price.

 Particulars Per unit Total year Sales (120000 x 10) 10.00 1,200,000.00 Less: Variable costs (120000 x 3) 3.00 360,000.00 Contributions 7.00 840,000.00 Less: Fixed costs 5.50 660,000.00 Per unit: (660000 / 120000) Net profit 1.50 180,000.00

Note: Except the increase in variable costs to 30% of selling price it has been assumed that no other changes have occurred in fixed and other costs of the organization (Bryce, 2017).

 Base case scenario (Normal circumstances) PV ratio 75 (Contribution per unit x 100/ Selling price per unit) BEP in sales (Fixed costs  /PV ratio) Fixed costs 660,000 PV ratio 75 BEP sales 880000 BEP in units (Fixed costs / Contribution per unit) BEP units 88000 Contribution per unit 7.5 Fixed costs 660000
 Increase in original selling price by 15% PV ratio 78.26 (Contribution per unit x 100/ Selling price per unit) BEP in sales (Fixed costs  /PV ratio) Fixed costs 660,000.00 PV ratio 78.26 BEP sales 843,341.00 BEP in units (Fixed costs / Contribution per unit) BEP units 73,334.00 Contribution per unit 9.00 Fixed costs 660,000.00
 Decrease in original selling price by 15% PV ratio 70.59 (Contribution per unit x 100/ Selling price per unit) BEP in sales (Fixed costs  /PV ratio) Fixed costs 660,000.00 PV ratio 70.59 BEP sales 935,000.00 BEP in units (Fixed costs / Contribution per unit) BEP units 110,000.00 Contribution per unit 6.00 Fixed costs 660,000.00
 Decrease in variable costs to 20% of selling price PV ratio 80.00 (Contribution per unit x 100/ Selling price per unit) BEP in sales (Fixed costs  /PV ratio) Fixed costs 660,000.00 PV ratio 80.00 BEP sales 825,000.00 BEP in units (Fixed costs / Contribution per unit) BEP units 82,500.00 Contribution per unit 10.00 Fixed costs 660,000.00
 Increase in variable costs to 30% of selling price PV ratio 70.00 (Contribution per unit x 100/ Selling price per unit) BEP in sales (Fixed costs  /PV ratio) Fixed costs 660,000.00 PV ratio 70.00 BEP sales 942,860.00 BEP in units (Fixed costs / Contribution per unit) BEP units 94,286.00 Contribution per unit 7.00 Fixed costs 660,000.00

Margin of safety:

 Base case scenario (Normal circumstances) Margin of safety (sales - Break even sales) 320,000.00 Margin of safety in % (sales - Break even sales) x100/ Sales 26.67 (Nosheen, Sadiq and Rafay, 2016)

## Scenario Analysis

 Increase in original selling price by 15% Margin of safety (sales - Break even sales) 536,659.00 Margin of safety in % (sales - Break even sales) x100/ Sales 38.89
 Decrease in original selling price by 15% Margin of safety (sales - Break even sales) 85,000.00 Margin of safety in % (sales - Break even sales) x100/ Sales 8.33
 Decrease in variable costs to 20% of selling price Margin of safety (sales - Break even sales) 375,000.00 Margin of safety in % (sales - Break even sales) x100/ Sales 31.25
 Increase in variable costs to 30% of selling price Margin of safety (sales - Break even sales) 257,140.00 Margin of safety in % (sales - Break even sales) x100/ Sales 21.43

Part c:

In order to calculate the percentage of net profits under different scenarios the following formula has been used:

Net profit x 100/ Sales

 Net profit as percentage Option Base case 20.00 Increase in original selling price by 15% 30.43 Decrease in original selling price by 15% 5.88 Decrease in variable costs to 20% of original selling price 25.00 Increase in variable cost to 30% of original selling price 15.00

It is clear from the above calculations that even slightest of changes in the underlying variables such as selling price and variable costs would significantly influence the amount of profit of the organization (Lehmann, 2016). With the original selling price of ?10 per unit and variable costs of ?2.50 per unit the organization is expected to earn net profit of ?240,000. The sensitivity analysis is conducted by the management to determine the implication of changes in underlying variables on the profitability of an organization.

It is clear from the information processed in the above document that the financial performance of the company is affected significantly due to changes in underlying conditions (Kumar, 2017). Thus, the financial performance of the company is quite sensitive to the underlying variables.

The increase in selling price by 15% would result in increase in net profit to ?420,000. Thus, a 15% increase in selling price would help the company to increase its net profit by as much as 75%. Thus, net profit of the company is very sensitive to the selling price of each unit of production (Rothaermel, 2015).

Similarly decrease in selling price by 15% to ?8.50 per unit would reduce the net profit of the company from ?240,000 to ?60,000. Hence, the net profit of the company would reduce by 75% subsequent to reduction of selling price by 15% from the original selling price of ?10.00 per unit (Lasserre, 2017).

As per the base case the variable costs is ?2.50 per unit, i.e. 25% of original selling price. However, slight decrease in variable costs to 20% of original selling price would increase the net profit of the company to ?300,000 (Rothaermel, 2015). This is an increase of ?60,000 in net profit which is an increase of 25% from original net profit as per the base case. Again the net profit of the company is very sensitive to the changes in variable costs. Similarly the increase in variable cost by 5% from 25% of original selling price to 30% of original selling price would result in decrease in net profit by 25% (Ho et. al. 2016).

It is clear from the above discussion that the net profit of the company is very sensitive to the underlying variables. Thus even a slightest change in the underlying variables would trigger a significant change in the net profit of the company. Hence, the management must take steps carefully to ensure that the company is in a position to increase its net profit in the future by improving its financial performance (Prajogo, 2016).

## Part a: Increase in Selling Price by 15%

Operational leverage is calculated by dividing the percentage of change in net profit of an organization with the percentage of change in sales of the organization. It helps to assess the operating leverage of the organization (Perin et.a l. 2016).

Operating leverage in case the selling price increases by 15% from the original selling price is calculated below.

Percentage of change in sales due to increase in selling price is calculated below:

(1380000 – 1200000) x 100/ 1200000 = 15% (Prajogo, 2016).

Calculation of percentage of change in net profit of the company due to the increase in selling price is provided below:

(420000 – 240000) x 100/240000 = 75%.

Thus, operating leverage would be as following:

Change in percentage of net profit / Change in percentage of sales. = 75% /15% = 5. Thus, the company has a huge operating leverage. This indicates that for each ? increase in selling price the operating profit of the company would increase by ?5 assuming other conditions remain unchanged (Iooss and Lemaître, 2015).

Again with the decrease in selling price of the company would similarly affect the net profit of the company. The following calculation would be helpful to understand the impact on net profit of the company due to the decrease in the selling price of the company.

In case the selling price decreases by 15% then the operating leverage would be as following:

Percentage of change in sales due to decrease in selling price is calculated below:

(1,020,000 – 1,200,000) x 100/ 1200000 = (15%).

Calculation of percentage of change in net profit of the company due to the increase in selling price is provided below:

(60000 – 240000) x 100/240000 = (75%).

The operating leverage would be as following:

Change in percentage of net profit / Change in percentage of sales. = (75%) / (15%) = 5. Hence, this indicates decrease of ?5 for each ? decrease in net selling price of unit sold by the company if other conditions remain unchanged.

As per the discussion above it has already seen how the changes in underlying conditions of the company changes the profitability of the company. The company’s profitability is very sensitive to the operating parameters. With minimum changes in the underlying conditions such increase and decrease of selling prices would influence the profitability of the company immensely. The company as per its base case scenario, i.e. with original selling price of ?10 per unit and variable cost of ?2.50 per unit with total fixed costs of ?660,000 is expected to earn a net profit of ?240,000. However, increase in net selling price by 15% would increase the net profit of the company by 75% to ?420,000 i.e. an increase of ?180,000. Similarly a decrease in net selling price by 15% would reduce the net profit of the company by similar margin ?180,000. This shows how sensitive the profitability of the company is to the underlying assumptions and variables.

## Part b: Decrease in Selling Price by 15%

However, it is important to note that changes in the underlying conditions have been considered one at a time. But an organization operates in an uncertain environment where the underlying conditions keep on changing and it is unrealistic to assume that only a single underlying variable would change at a time. Thus, in scenario testing a brief calculation will help to assess the impact on net profit of the company in case there is more than one changes in the underlying variables at a time (Renz, 2016).

Suppose that along with increase in net selling price the expected sales of the company would reduce in proportion to the increase in net selling price. Then the impact on net profit of the company is calculated below.

 Particulars Per unit (?) Total year (?) Sales (102000 x 11.50) 11.50 1,173,000.00 Less: Variable costs (102000 x 2.5) 2.50 255,000.00 Contributions 9.00 918,000.00 Less: Fixed costs 5.50 660,000.00 Per unit: (660000 / 120000) Net profit 3.50 258,000.00 Expected sales at 11.50 per unit (120000 x 85%) 102000

Thus, even if the increase in net selling price results in decrease in proportionate sales units even then the company would be able to increase higher profit than under base case scenario.

Similarly in case the decrease in net selling prices would increase the sales unit proportionately then the impact on net profit of the company is calculated below.

 Particulars Per unit (?) Total year (?) Sales (138000 x 11.50) 8.50 1,173,000.00 Less: Variable costs (138000 x 2.5) 2.50 345,000.00 Contributions 6.00 828,000.00 Less: Fixed costs 5.50 660,000.00 Per unit: (660000 / 120000) Net profit 0.50 168,000.00 Expected sales at 11.50 per unit (120000 x 85%) 138000

As can be seen that the net profit of the company would decrease with the decrease in net selling price of the company however, the decrease would be significantly less as compared to the scenario where no increase in selling units is expected from the decrease in net selling price (Sofat and Hiro, 2015).

Conclusion:

The discussion about the expected financial performances of the company with the different underlying assumptions shows that the sensitivity analysis on the financial performance of an organization provides the management with significant amount of information as to the expected financial performance of the company under different circumstances. Such analysis helps the management to take important decisions in relation to the management of an organization.

References:

Bryce, H.J., 2017. Financial and strategic management for nonprofit organizations. Walter de Gruyter GmbH & Co KG.

Ho, K.L.P., Nguyen, C.N., Adhikari, R., Miles, M.P. and Bonney, L., 2017. Leveraging innovation knowledge management to create positional advantage in agricultural value chains. Journal of Innovation & Knowledge. Available at: https://www.sciencedirect.com/science/article/pii/S2444569X17300574 [Accessed on 10 November 2018]

Iooss, B. and Lemaître, P., 2015. A review on global sensitivity analysis methods. In Uncertainty management in simulation-optimization of complex systems (pp. 101-122). Springer, Boston, MA.

Karadag, H., 2015. Financial management challenges in small and medium-sized enterprises: A strategic management approach. EMAJ: Emerging Markets Journal, 5(1), pp.26-40.

Kumar, R., 2017. Strategic Financial Management Casebook. Academic Press.

Lasserre, P., 2017. Global strategic management. Macmillan International Higher Education.

Lehmann, D., 2016. MBA8420-M15. Strategic Financial Analysis. Su16. Lehmann, Dan.

Nosheen, S., Sadiq, R. and Rafay, A., 2016, September. The primacy of innovation in strategic financial management-understanding the impact of innovation and performance on capital structure. In Management of Innovation and Technology (ICMIT), 2016 IEEE International Conference on(pp. 280-285). IEEE.

Perin, M.G., Sampaio, C.H., Jiménez-Jiménez, D. and Cegarra-Navarro, J.G., 2016. Network effects on radical innovation and financial performance: An open-mindedness approach. BAR-Brazilian Administration Review, 13(4).

Prajogo, D.I., 2016. The strategic fit between innovation strategies and business environment in delivering business performance. International Journal of Production Economics, 171, pp.241-249.

Prajogo, D.I., 2016. The strategic fit between innovation strategies and business environment in delivering business performance. International Journal of Production Economics, 171, pp.241-249.

Renz, D.O., 2016. The Jossey-Bass handbook of nonprofit leadership and management. John Wiley & Sons.

Rothaermel, F.T., 2015. Strategic management. McGraw-Hill Education.

Rothaermel, F.T., 2015. Strategic management. McGraw-Hill Education. Available at: https://dspace.elib.ntt.edu.vn/dspace/bitstream/123456789/7607/1/Frank%20Rothaermel-Strategic%20Management.pdf [Accessed on 10 November 2018]

Sofat, R. and Hiro, P., 2015. Strategic financial management. PHI Learning Pvt. Ltd..

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