Applying Differential Analysis to Profitability Scenarios

Assume that Company A and Company B sell a microwave popcorn popper for $$20.$ Although the companies have different cost structures, both companies currently show a profit of $$39,000$ based on sales of $26,000$ units as shown in the following financial statements for the month of June. Both companies hold no inventory and sell contractual orders in the month.

For the Month of June Company A Company B

Sales $($$$20)$ $$520,000$ $$520,000$

Variable cost of goods sold $($$$5\mathrm{.}00,7\mathrm{.}50,$ Company A and B$,$ respectively$)130,000195,000$

Variable selling and administrative costs $($$$2\mathrm{.}00,$ $$4\mathrm{.}00,$ Company A and B$,$ respectively$)52,000104,000$

Contribution margin $338,000221,000$

Fixed cost of goods sold $195,000130,000$

Fixed selling and administrative costs $104,00052,000$

Profits Before$-$Tax $$39,000$ $$39,000$

REQUIRED

Due to an expected downturn in market conditions, both companies are forecasting the effect on profitability of different scenarios on monthly profit.

a$.$ For each company, determine the impact on monthly profit using differential analysis for each of the following separate scenarios.

$1.$ Sales volume decreases to $20,800$ units for the month for both companies.

Note: enter an increase in profits as positive; enter a decrease in profits as negative.

Company A Company B

Net change on June profits: Answer

Answer

$2.$ Both companies drop the selling price per unit to $$18\mathrm{.}50$ which results in unit sales of $23,400$ units for the month.

Note: enter an increase in profits as positive; enter a decrease in profits as negative.

Company A Company B

Net change on June profits: Answer

Answer

$3.$ Both companies drop the selling price per unit to $$18\mathrm{.}50$ which results in unit sales of $23,400$ units for the month. In addition, both companies decrease the quality of materials used which drops variable cost of goods sold by $$0\mathrm{.}20$ per unit. Both companies eliminate a part$-$time administrative position reducing fixed costs by $$6,500$ per month.

Note: enter an increase in profits as positive; enter a decrease in profits as negative.

Company A Company B

Net change on June profits: Answer

Answer

b$.$ Are the companies profitable in June after cost cutting measures are considered $($part a$(3))?$

Company A Company B

Answer

Answer

Note: enter an overall profit as a positive amount and enter an overall loss as a negative amount.

Company A Company B

Overall profit $($loss$)$ Answer

Answer

c$.$ Even though the reactions of Company A and Company B to declining market condition are similar, why do the financial results differ?

The reactions to the declining market conditions $($cost cutting measures$)$ are similar, but Company A shows Answer

negative impacts. This is due to the cost structure. Company A carries Answer

fixed costs and Answer

variable costs. In market downturns that impact volume, Answer

remain for Company A $($except for targeted reduction measures$).$ Company B$,$ with a higher proportion of Answer

$,$ eliminated ratably Answer

of these costs when volume reduced. Thus, companies that have a higher leverage, report losses Answer

quickly that do companies with less leverage.

Would you suggest additional cost$-$cutting measures? Which one of the following statements is false?

Answer

a$.$ Additional cost cutting measures may be required in the short$-$run, depending on how long the down$-$turn is expected to last.

b$.$ Both companies may be able to rent out excess capacity in the short$-$term to offset losses.

c$.$ In the long$-$term, Company A may want to shift its cost structure to more variable costs and less fixed costs in order to be able to have the flexibility to manage future downturns.

d$.$ Both companies may consider the production of a different product with its excess capacity that has lower margins.