Operating income of $7,050,000 results from increasing fixed costs by 20%, not reducing them by 20%. The expected total fixed cost for the current year is $60 × 150,000, or $9,000,000. Fixed cost should decrease by 20% for the coming year.
The contribution margin here is calculated by recalculating the variable costs with the expected 20% reduction and multiplying the resulting per unit contribution margin by the current year’s expected volume of 150,000 units. The total contribution margin for the coming year should be based on the next year’s expected volume.
$72 is the current per unit contribution margin of $90 ($150 ? $60) reduced by 20% ($90 × .80). However, it is variable costs that are expected to be reduced by 20%, not the contribution margin. A per unit fixed cost of $55 would result from dividing the expected cost reduction of $750,000 by the current year’s anticipated volume of 150,000 units. However, fixed costs do not change with levels of sales or production as long as the volume remains within the relevant range; and so they should not be evaluated on a per unit basis but should be evaluated in total.
The best way to solve this is to prepare an income statement that incorporates the sales for the coming year and the cost management initiatives, and then calculate the items in each answer choice. Sales 175,000 units @ $150 $26,250,000 Variable Costs 175,000 units @ ($60 × .8) 8,400,000 Contribution Margin $17,850,000 Fixed Costs ($60 × 150,000) ? $750,000 8,250,000 Operating Income $9,600,000 The variable cost ratio is 8,400,000 ÷ 26,250,000 = .32; and operating income is $9,600,000.
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Sales for the coming year are estimated at 175,000 units, which is within the relevant range of Phillip's cost structure. Cost management initiatives are expected to yield a 20% reduction in variable costs and a reduction of $750,000 in fixed costs. Phillip's cost structure for the coming year will include a