Question 12.A.2: Fixed Costs and Fluctuations in EBIT PROBLEM: As you prepare...
Fixed Costs and Fluctuations in EBIT
PROBLEM: As you prepare the financial forecast for your computer-support business, you worry about the impact of fluctuations in the number of house calls on EBIT. You decide to examine how converting some fixed costs to variable costs will affect the sensitivity of EBIT to changes in the number of house calls. In a conversation with the manager at the radio station where you would be advertising, you discover that instead of paying $1,500 per month under a long-term advertising contract, you can get the same level of advertising for $1,600, where $1,000 of the total cost is fixed and $600 is variable. That is, in a given month, if you used the full level of advertising, you would pay $1,600, but you would also have the ability to reduce advertising costs to $1,000 by cutting back on the number of advertisements. You wonder how this contract would affect the sensitivity of EBIT to a decrease in the monthly number of house calls—say, from 120 to 90.
APPROACH: To determine how the sensitivity of EBIT differs between the $1,500 per month long-term contract and the contract that has only $1,000 of fixed costs, you must calculate EBIT under each alternative contact for 120 house calls and for 90 house calls. Using these EBIT values, you must next calculate the percentage decrease in EBIT if the number of monthly house calls declines from 120 to 90 for each alternative. You can then compare the percentage decreases to see the difference in the sensitivity of EBIT to the decrease in the number of house calls.
$1,500 monthly fixed contract: As we determined in Learning by Doing Application 12.1, EBIT is $2,000 with 120 house calls per month. With 90 house calls per month instead of 120, revenue would be $6,300 ($70 per house call × 90 house calls = $6,300) per month instead of $8,400 ($70 per house call × 120 house calls = $8,400) and EBIT would decline to $500:
\begin{matrix} EBIT &=& Revenue-VC-FC-D\&A \\ &=&\$6,300-(\$20 \times 90)-\$3,000-\$1,000 \\ &=& \$500 \end{matrix}This represents a 75 percent decrease in EBIT ([$500 − $2,000]/$2,000 = −0.75, or−75 percent).
$1,600 monthly contract with $1,000 fixed: Switching to the alternative advertising arrangement would increase unit variable costs by $5 ($600/120 house calls = $5 per house call) but would decrease fixed costs by $500 ($3,000 − $2,500 = $500). EBIT with 120 house calls per month would equal $1,900:
With 90 house calls, EBIT would decline to $550:
EBIT = \$6,300-(\$25 \times 90)-\$2,500 -\$1,000 = \$550This represents a 71 percent decrease in EBIT [($550 − $1,900)/$1,900 = −0.71, or −71 percent].
If the business averaged 120 house calls per month, EBIT under the alternative advertising arrangement would be $100 lower than EBIT under the original advertising arrangement. However, it would actually be $50 higher if the business averaged only 90 house calls per month because you would be able to cut back on advertising expenses under the alternative agreement if demand was poor^3.