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 thecompanys three products, as shown below. The analysis was based on data from last years accountingrecords.

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

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 hehad updated the prior years information for expected changes. Ahmed said he had thought about doing that,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. Ahmedspresentation was the last item on the agenda, and Mohsen finally introduced him and explained Ahmedsinterest 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.

Salem, Manufacturing Manager: You know, Ahmed, the sales department estimates that unit sales should increase next year. And were at over 80% capacity now. Im not sure about the exact size of the increase, but I know that well be pushing the limits of our capacity, at least.

Ahmed: Once we estimate the sales volume, I can just put that into my projections and well know a lot moreabout next years profits.

Salem: Heres the problem, though. If we increase production above 90 percent of capacity, we'll need to invest more to operate the plant. Were already planning to buy equipment that will increase fixed costs by at least $25,000 a month. In addition, at 90 percent of plant capacity well face bottlenecks,and production might slow down some. And from your data, it looks like Motor 15 is not really profitable. What if we drop it? That would ease the capacity problems.

Ahmed: Well, Im not sure exactly what will happen if we drop Motor 15. Ive just spread the fixed costs across the units using an allocation. Im not sure how fixed costs would change if we drop Motor 15.

Bayan, Sales Manager: Why do you want to drop Motor 15? Motor 5 is the product with slowing sales. I expect it to drop by at least 20,000 units next year. But we ought to pick up that 20,000 and maybeanother 25,000 from Motor 15 production. Motor 10 sales havent changed for a while and should continue to remain pretty stable.

Ahmed: Well, Ill make those changes.

Bayan: Wait, theres more. We've been thinking about changing the price for Motor 15. I think were sufferingfrom reputation problems with that motor. Some of our customers have asked if were maintainingour usual quality at that low price. My sales people seem to think that we could increase the price by 25% and still increase sales.

Fahad, Vice President: As long as you're considering possible changes for next year, let's see what I can add to the picture.

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 thatequipment 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 atleast 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 marginthey bring in, instead of sales. Third, I guess its time to change our product emphasis. No one seemsto 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 ofMotor 15, its likely that Motor 5 will become a loser for us. Maybe its time that we drop it. Can youincorporate these changes right now?

Mohsen: Thanks, Fahad. I thought wed get a good discussion going about future plans once Ahmed made hispresentation. This CVP approach is something that we havent used before, but as you can see, you'veall got information to share. Ahmed will need some time to rework his analysis with this newinformation, 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 questionsthat 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 individualproduct 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 numbersand think about them for a few days. Well meet again next week. Ahmed can bring the laptop, andwe 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 getinformation. Its a waste of time for all of us to meet just to give you information. And send the CVP out aheadso 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 betterinformation, 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 thataffect the accuracy of our results. Next time you go out to ask for it, theyll know that they need to give ustheir best estimates. Otherwise, they might just give us something off the top of their heads because theydont want to take time from other tasks.

Required:

1. List the assumptions implicit in Ahmeds calculation of the breakeven point. (Hint: List the generalassumptions 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.