Elina Siljander owns Elina’s Stained Glass in Helsinki, Finland.

The business produces and

sells three different types of stained glass windows: small, medium, and large. Elina has two
full-time employees who work regular schedules to cut glass and assemble the windows.
She borrowed money from the bank to start the business and pay living expenses. She is
concerned that her cash fl ows might not be high enough either to pay herself or to repay the
bank loan. She would like to generate approximately €10,000 in pretax earnings each month
to cover her living expenses and repay the loan.
The following revenue and cost information covers the past four months:

REQUIRED
A. Develop a cost function for Elina’s Stained Glass.
B. Determine the level of revenue Elina’s Stained Glass must generate to achieve the
targeted profi t of €10,000 per month.
C. Calculate Elina’s degree of operating leverage for September.
D. Interpret Elina’s degree of operating leverage.
E. Create a CVP graph that shows the breakeven point, target profi t, and margin of safety.
F. Write a memo to Elina with recommendations about ways she might achieve her goals.

SOLUTION

A. Below is one solution for the cost function. This solution involves a number of
judgments about cost classification and choice of estimation methods. Other
reasonable solutions are possible, particularly for “raw materials and supplies” and
“miscellaneous.”
Labour and rent costs are most likely fixed. Rent is usually a fixed cost, and labour
appears to be fixed for this company because the employees work regular schedules.
Both of these costs are estimated based on the most recent month’s information. This
procedure will incorporate the apparent rent increase that took place in September
and the most recent employee schedules and pay rates. Therefore, the rent cost is
estimated at €2,200, and the labour cost is estimated at €4,282.

Raw materials and supplies for a manufacturing organization are most likely to be
variable. No information is provided about alternative cost drivers, so this solution
estimates raw materials and supplies as a percentage of revenue. This treatment is
reasonable because these types of costs and revenues both tend to vary with the size
of window. If raw material and supply costs change over time, then it is best to use
the most recent information available. Therefore, this variable cost is estimated using
the most recent month’s data:

€4,029/€16,116 = 25% of revenue

No information is provided about the nature of the miscellaneous cost.

Miscellaneous might include direct costs such as packing materials for the windows
and indirect costs for supplies used in the office. Also, this cost appears to have
increased along with the increases in revenues over the four months presented. The
scatter plot shown below is used to further analyze the relationship.
The scatter plot seems to confirm a positive relationship between miscellaneous
costs and revenues. Therefore, regression analysis will be used to estimate the cost
function for miscellaneous costs, with revenues as the independent variable. Portions
of the regression output are shown below.
Regression Statistics
Multiple R 0.873015438
R Square 0.762155955
Adjusted R
Square 0.643233932
Standard Error 69.99280477
Observations 4

Standard
  Coefficients Error t Stat P-value
Intercept 288.5314984 162.9787289 1.770363 0.218684
X Variable 1 0.033136813 0.013089407 2.531575 0.126985

Based on the regression results, the miscellaneous cost function is estimated as:

TC = €289 + 3% of revenues
 Given the following summary of individual cost functions, the total cost function for
Elina's is TC = €6,771 + 28% of total revenue.
Cost Category Fixed Variable
Raw materials and supplies €0 25% of total revenue
Labour 4,282
Rent 2,200
Miscellaneous 289 3% of total revenue
Total €6,771 28% of total revenue

B. The monthly amount of revenues needed to generate profit of $10,000 per month is:

C. The degree of operating leverage for September was:

[€16,116*(1-0.28)]/€4,812 = 2.41

D. If sales decrease by 10%, profit decreases by about 24% (10% * 2.41). Elina’s cost
structure includes a large proportion of fixed costs.

E.
F. There are many different ways to write a memo to Elina. Following are points that
should be covered in the memo.

• The CVP analysis indicates that Elina must achieve a substantial increase in
revenues to achieve targeted profit of €10,000 per month. Revenue would
have to increase by €7,177 over September's level, or 45% (€23,293-
€16,116)/€16,116 = 0.45).
• The CVP graph and degree of operating leverage indicate that fixed costs are
a large portion of total costs. If Elina believes that this is too much risk, she
will need to find a way to increase revenue without increasing fixed costs.
• Here are a few possible recommendations for increasing revenues. She could
offer classes in the evening to develop a larger clientele for her work. She
could sell stained glass pieces and supplies to people taking classes and to
others who produce stained glass for hobby purposes. Both of these plans are
unlikely to increase fixed costs by much since employees are currently idle
part of the time. (However, she would need to invest in higher inventories.)