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Sams makes axes for the dwarf lords of Moria and sells them in cases of 30 assorted axes....

Question:

Sams makes axes for the dwarf lords of Moria and sells them in cases of 30 assorted axes. Although Sams makes a variety of axes, the cost differences are insignificant, and the cases all sell for the same price.

Sams has a total capital investment of $10,000,000. It expects to produce and sell 400,000 cases of axes next year, as demand has gone up because of Orc threats. Sams requires a 12% target return on investment.

Expected costs for the next year are:

Variable production costs $3.00 per case
Variable marketing and distribution costs $2.00 per case
Fixed production costs $400,000
Fixed marketing and distribution costs $700,000
Other fixed costs $500,000

Sams prices the cases at full cost plus markup to generate profits equal to the target return on capital.

a) What is the target operating income?

b) What is the selling price Sams needs to charge to earn the target operating income? Calculate the markup percentage on the full cost.

c) Sams is considering increasing its selling price to $13 per case. Assuming production and sales decrease by 10%, calculate Sams' return on investment. Is increasing the selling price a good idea?

Operating Income

Operating income is the excess of net sales over all operating costs or expenses incurred by the business. Such operating costs and expenses include variable and fixed and could be direct or indirect.

Answer and Explanation:

a) The target operating income would be 12% of the capital investment, as follows:

Capital Investment $10,000,000
Target return on investment 12%
Target operating income $1,200,000

b) The target selling price and markup percentage would be computed as follows:

Variable production costs (400,000 cases @ $3.00) $1,200,000
Variable marketing and distribution costs (400,000 cases @ $2.00) $800,000
Fixed production costs $400,000
Fixed marketing and distribution costs $700,000
Other fixed costs $500,000
Total costs $3,600,000
Add: Target operating income $1,200,000
Total target sales $4,800,000
Divide by: Number of cases 400,000 cases
Target selling price $12
Markup percentage (Operating income / Total costs) 33.33%

c) Situation in increase in selling price is computed as follows:

Sales (400,000*90%*$13) $4,680,000
Less: Total costs
Variable production costs (400,000 cases *90% @ $3.00) $1,080,000
Variable marketing and distribution costs (400,000 cases * 90% @ $2.00) $720,000
Fixed production costs $400,000
Fixed marketing and distribution costs $700,000
Other fixed costs $500,000
Total costs $3,400,000
Operating income $1,280,000
Divide by: Capital Investment $10,000,000
Return on Investment 12.80%

It would be a good idea to increase the selling price, because the operating income and return on investment would be at 12.80%, which is higher than target return of 12%.


Learn more about this topic:

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Operations of an Income Statement

from Accounting 101: Financial Accounting

Chapter 8 / Lesson 5
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