The president does not want to change the selling price. Instead, he wants to increase the sales commission by $1.70 per unit. He thinks that this move, combined with some increase in advertising, would increase this year's sales by 25%. How much could the president increase this year's advertising expense and still earn the same $360,000 net operating income as last year?

Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for $80 per unit. Variable expenses are $40.00 per unit, fixed expenses total $200,000 per year. Its operating results for last year were as follows:

Sales $2,160,000

Variable expenses $1,080,000

Contribution margin $1,080,000

Fixed expenses $200,000

Net operating income $ 880,000

$732,625

Explanation:

The contribution per unit is:

Contribution per unit = Selling price per unit - variable cost per unit - Sales commission per unit

Contribution per unit = $80 - $40 - $1.7 = $38.3 per unit

The increase in advertisement expense can be calculated under the new condition by the following formula:

New Sales ($) = (Fixed cost + Profit) * Sales Prices per unit  / Contribution Per unit

By putting values we have:

$2,160,000 * 125% = (Fixed cost + $360,000)* $80 per unit / $38.3 per unit

$2,700,000 * $38.3 per unit / $80 per unit  = Fixed Cost + $360,000

$1,292,625 - $360,000 = Fixed Cost

Fixed Cost = $932,625

This means that the maximum amount of increase in the advertisement expense would be $732,625 to earn a profit of $360,000

The president must increase the advertising expense by $687, 700.

Explanation:

The president must increase the advertising expense by $687, 700.

If we were to compute the income statement for the year,  

Sales would increase by 25%: $2, 280, 000 x 125% = $3, 600, 000

Variable expenses would increase by the increase in sales commission pf $1.70 per unit:  

$1.70 x 19, 000 units = $32, 300

Total variable expense = $1, 440, 000 + $32, 300 = $1, 472, 300

[We arrived at 19, 000 by dividing the sales value of $2880, 000 by the selling price of $120

$2, 880, 000 / $120 = 19, 000 units.]

In order to determine by how much the advertising expense should increase by, we need to compute the income statement.

Sales             $3, 600, 000

Less: Variable expenses-$1, 472, 300

Contribution margin  $2, 127, 700

Fixed cost (given)  $160, 000

Advertising increase  x

Net operating income  $1, 280, 000

To determine the value of the advertising expense, we need to work backwards. Subtract the net operating income value and the fixed cost value from the contribution margin.

Therefore,  

$2, 127, 700 - $1, 280, 000 - $160, 000 = $687, 700

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