Case 2: National Motors is a small company that produces motors for specialized equipment sold primarily to research laboratories and a major defense contractor. The operation is family owned and has been in business for 15 years. The company produces and sells three motors, named Motor 5, Motor 10, and Motor 15. Ahmed was recently hired as an accountant and reports to the controller, Mohsen. Ahmed has been performing routine types of accounting work, but he would like to become more involved in cost control and in analyses to help the managers make decisions. Recently, he performed a cost-volume-profit analysis of the companys three products, as shown below. The analysis was based on data from last years accounting records. Prior Year Data Aggregate Motor 5 Motor 10 Motor 15 Sales at capacity (units) 300,000 Actual volume (units) 250,000 120,000 80,000 50,000 Price per unit $113.60 $140.00 $120.00 $40.00 Total revenue $28,400,000 $16,800,000 $9,600,000 $2,000,000 Variable cost per unit $85.60 $125.00 $62.50 $28.00 Total variable cost $21,400,000 $15,000,000 $5,000,000 $1,400,000 Fixed costs $6,000,000 $900,000 $4,500,000 $600,000 Operating profit $1,000,000 $900,000 $100,000 $0 Ratios: Variable cost to sales 75.352% 89.286% 52.083% 70.000% Contribution margin ratio 24.648% 10.714% 47.917% 30.000% Utilization of capacity 83.333% 40.000% 26.667% 16.667% Breakeven point: Units 214,286 Revenues $24,342,857 San Jose Motors $0 $10,000,000 $20,000,000 $30,000,000 $40,000,000 $50,000,000 0 100,000 200,000 300,000 400,000 Units Ahmed asked Mohsen for an opportunity to present his CVP analysis at the next weekly managers meeting. Mohsen had used CVP in the past, but had not formally presented it to the managers. She asked Ahmed if he had updated the prior years information for expected changes. Ahmed said he had thought about doing that, Total Revenue Total Cost 3 but did not know where to get that kind of information. Mohsen suggested that he bring his laptop to the meeting and ask for updated information from the managers at the meeting. The following managers attended the meeting: Salem, Manufacturing Manager Bayan, Sales Manager Lamia, Purchasing Department Manager Sara, Research and Development Manager Kamil, Engineering Manager Fahad, Vice President Mohsen introduced Ahmed to the people he had not already met, and then the meeting began. Ahmeds presentation was the last item on the agenda, and Mohsen finally introduced him and explained Ahmeds interest in cost control and analysis. Ahmed distributed copies of his CVP data and chart. He described the calculations and explained how the chart indicated a profitable year, if the volume of sales activity continued as it had in the past. He explained that he had not had time to update the information and would like others at the meeting to give him information that would improve his projections. Following are the comments at the meeting 4 First, it seems that taxes arent considered here. We always give the government about 30% of our profits. And then well need to keep some money back for reinvestment. Weve got to buy that equipment to increase capacity, and that will require another $500,000, at least. Second, the union wants a raise for the production crew. Our variable costs will probably increase by at least 5%. If we give those people an increase, wed better be thinking about raises for management, too. We usually give bonuses based on profits and set aside maybe $500,000 for that. In addition, maybe we need to revisit the way that we give bonuses to the sales force. They get their salaries, plus a commission per unit based on price. Maybe we should base their bonus on the contribution margin they bring in, instead of sales. Third, I guess its time to change our product emphasis. No one seems to know which motor is most profitable. The sales staff are just responding to demand and not really pushing any of our motors. Right now Motor 5 is still covering its costs, but if we produce more of Motor 15, its likely that Motor 5 will become a loser for us. Maybe its time that we drop it. Can you incorporate these changes right now? Mohsen: Thanks, Fahad. I thought wed get a good discussion going about future plans once Ahmed made his presentation. This CVP approach is something that we havent used before, but as you can see, you've all got information to share. Ahmed will need some time to rework his analysis with this new information, but Im sure he can get a revision out to us by tomorrow morning. It seems that Ahmeds presentation is based on some important assumptions. Most of the questions that were raised were really about those assumptions. It might help us all if Ahmed lists those assumptions so that we can see how they influence the analysis. Then, hell have to incorporate the increase in unit sales and see whats going on with individual product lines. Also, lets see how things change with changes in product mix, and we may want to drop Motor 5. Ahmed will have to incorporate price changes and consider taxes, investment, and raises. Then he can look at the effect of product emphasis. That should about do it. Once we get Ahmeds revised analysis, we can all take a look at the numbers and think about them for a few days. Well meet again next week. Ahmed can bring the laptop, and we can do some what if analysis on the spot. As he was leaving, Salem said, Ahmed, before we meet next time, go down to the production floor and get information. Its a waste of time for all of us to meet just to give you information. And send the CVP out ahead so we can think more about changes that could occur next year. Also, bring a computer projector so we can all see how any changes affect overall results, then we can make plans for the next period with better information, and well not be caught off guard so often. Ahmed was annoyed that Mohsen hadnt told him to go down to the production floor and over to marketing earlier. He also realized that he should have thought about bringing a projector. When he asked Mohsen about it, he said, Sometimes when were introducing a new type of analysis, people need to understand how important their information is to us. Today several people contributed important pieces of information that affect the accuracy of our results. Next time you go out to ask for it, theyll know that they need to give us their best estimates. Otherwise, they might just give us something off the top of their heads because they dont want to take time from other tasks. 5 Required: 1. List the assumptions implicit in Ahmeds calculation of the breakeven point. (Hint: List the general assumptions of CVP analysis, and then apply those assumptions specifically to this case.) 2. Create a spreadsheet that can be used for sensitivity analysis. 3. List the possible choices given in the case for the amount of (a) fixed cost, (b) the volume per product, and (c) the variable costs. 4. Pick specific values from Part 3 to use in the spreadsheet and explain why you chose each one. 5. What is the breakeven point in revenues? 6. Calculate the margin of safety in revenues and calculate operating leverage. 7. At what level of operations will the investment in capacity be covered, ignoring the anticipated increase in labor costs and salaries? 8. At what level of operations will the company be able to meet union demands, ignoring any bonuses for management? 9. At what level of operations will the company be able to increase capacity and give raises to laborers and management? 10. How much can the company spend on new investments for additional capacity, above the planned level of investment? 11. How can the breakeven analysis help the managers decide whether to alter the existing product emphasis? 12. What factors limit the usefulness of this type of CVP analysis? 13. Explain how and why biases might affect the CVP analysis for this company.