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Cyprus Fuel Project - Cost Volume Profit case

Cyprus Fuel Project manufactures and sells a single product, EcoPlus, a fuel saving device for motor vehicles in the domestic market. The Project commenced business operations on January 2010 and sales in the first six months were brisk due to the world wide increase in fuel prices. However the second half the year saw a drop in sales as a result of more competing companies entering the market and a gradual reduction in fuel prices.

The following summarised profit and loss account has been prepared by the previous management accountant:

YEAR 2010 1st half year 2nd half year
£000 £000 £000 £000
- 1st half: 35,000 units

- 2nd half: 25,000 units 1,000
Direct materials 350 250
Direct labour 280 200
Manufacturing overheads 245 195
Administration overheads 15 15
Selling overheads* 165 1,055 145 805
Net profit 345 195

* Selling overheads include sales commission of 5% based on sales value.

The Project Manager (PM), an engineer who founded the Project, recently attended a seminar at ELU for non-accountants on 'Cost-Volume-Profit Analysis and its benefits'. Although he found the seminar interesting, he would like to know more about the following:

(a) How does the economist's breakeven chart differ from the accountant's breakeven chart?

(b) The term 'fixed cost' has been explained in the seminar as 'a cost that remains unchanged when production activity changes over a period of time and over a certain relevant range'. He is unsure of what is meant by 'period of time' and 'relevant range' as he believes that there's no such thing as a fixed cost and that all costs are variable in the long term.

(c) An explanation of the breakeven point and margin of safety of the Project based on its present cost structure for the 2nd half year of 2010, and a brief explanation of the High-Low method of cost estimation used in your calculations, including its weaknesses as well as suggesting an alternative method.

The marketing manager feels that the current marketing strategy used by the Project is no longer effective. The Project presently employs a large sales staff on a 3 monthly contractual basis and are paid a basic salary together with a sales commission. The sales staff needs to fulfil the monthly sales quota set by the Project for their contract to be renewed further.

The marketing manager has suggested the following proposals to stop the decline in sales for the next six months:
Proposal 1

Rent floor space in busy shopping malls located in other major cities not served by the current sales staff and set up booths using the rented space to promote and sell the Project's product. Some of the existing sales staff will be seconded to manage these booths.

Spend an extra £38,000 on advertising and promotional materials. Rental of floor space would amount to £72,000.

The marketing manager is confident that together with a 5% reduction in unit selling price, sales volume will increase by 30% over the 2nd half year sales of 2010. Unit material cost will be reduced by 5% due to bulk discount. It is assumed that all other costs remain unchanged.

Proposal 2

Reduce the present number of sales staff by not renewing the contracts of those who failed to fulfil the sales quota set by the Project. Appoint workshops/garages (motor vehicle repair shops) and shops selling car accessories to be the Project's authorised dealers.

Additional promotional materials (posters, leaflets etc.) for the authorised dealers would cost £15,000. Fixed selling overheads (i.e. salaries of sales staff) will be reduced by £75,000.

The marketing manager is confident that with a 10% reduction in unit selling price and a sales commission of 18% of selling price to be paid to all authorised dealers and remaining sales staff, the sales volume will increase by 15% over the 2nd half year of 2010 sales. Unit material cost will be reduced by 3%. It is assumed that all other costs will remain unchanged.

You are required to write a report to the Project Manager discussing the points raised by him and to evaluate the two proposals put forward by the marketing manager.
Your report should include:
1. The report should have a title page and contents page
2. An introduction, setting out the topics to be covered
3. A discussion on the three points raised by the managing director
4. A breakeven graph and profit-volume graph for each proposal indicating the breakeven points and margin of safety. Verify your answers by calculations. All graphs are to be drawn and computations be made using MS Excel spreadsheet.
5. A comparison between the two proposals clearly stating any assumptions made.
6. A recommendation to the managing director on which proposal to accept
7. References both in the text and in a Reference List
8. Sections should have numbers and headings

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Solution Preview

I responded to the project manager's questions and created breakeven and margin of safety computations for status quo, proposal 1 and ...

Solution Summary

I responded to the project manager's questions and created breakeven and margin of safety computations for status quo, proposal 1, and proposal 2. Four graphs are prepared for your inspection--breakeven and profit volume graphs for both proposals. A short discussion (two paragraphs) explains why neither proposal would increase overall profits and therefore both should be rejected. A schedule of profits illustrates the conclusion. This gives you enough data, exhibits and comments to draft your paper as OTAs cannot write the paper for you.