Problem 10 - Accounting

Question

For a recent year, McDonald's company-owned restaurants had the following sales and expenses (in millions): \begin{tabular}{lr} Sales & \(\frac{\$ 16,083}{\$ 5,350}\) \\ Food and packaging & 4,185 \\ Payroll & 4,006 \\ Occupancy (rent, depreciation, etc.) & 2,340 \\ General, selling, and administrative expenses & \(\$ 15,881\) \\ \hline Income from operations & \(\$ 202\) \\ \hline \end{tabular} Assume that the variable costs consist of food and packaging, payroll, and \(40 \%\) of the general, selling, and administrative expenses. a. What is McDonald's contribution margin? Round to the nearest million. b. What is McDonald's contribution margin ratio? Round to one decimal place. c. How much would income from operations increase if same-store sales increased by \(\$ 500\) million for the coming year, with no change in the contribution margin ratio or fixed costs?

Step-by-Step Solution

Answer

a. Contribution margin is 1,540 million. b. Contribution margin ratio is 9.6%. c. Income increases by 48 million.

Step 1: Calculate Variable Costs

First, identify the variable costs based on the given information. The variable costs include food and packaging, payroll, and 40% of the general, selling, and administrative expenses.\- **Food and packaging**: 4,185 million\- **Payroll**: 4,006 million\- **Variable portion of General, Selling, and Administrative Expenses** = 40% of 15,881\\(\text{Variable portion of General, Selling, and Administrative Expenses} = 0.4 \times 15,881 = 6,352.4\text{ million} \ \text{Total Variable Costs} = 4,185 + 4,006 + 6,352.4 = 14,543.4\text{ million} \)

Step 2: Calculate Fixed Costs

Now calculate fixed costs. Fixed costs are the remainder of the general, selling, and administrative expenses after subtracting the variable portion that we calculated previously.\\(\text{Fixed General, Selling, and Administrative Expenses} = 15,881 - 6,352.4 = 9,528.6\text{ million} \)

Step 3: Calculate Contribution Margin

The contribution margin is the difference between sales and variable costs. The formula is: \(\text{Contribution Margin} = \text{Sales} - \text{Variable Costs} \ = 16,083 - 14,543.4 = 1,539.6\text{ million} \)\Round this to the nearest million: 1,540 million.

Step 4: Calculate Contribution Margin Ratio

The contribution margin ratio is the contribution margin divided by total sales, expressed as a percentage.\\(\text{Contribution Margin Ratio} = \left( \frac{1,540}{16,083} \right) \times 100 = 9.6\% \)

Step 5: Determine Increase in Income from Operations with Increased Sales

If same-store sales increase by \(500\) million, the increase in income from operations can be calculated by multiplying the increase in sales by the contribution margin ratio:\\(\text{Increase in Income} = 500 \times 0.096 = 48\text{ million} \)

Key Concepts

Variable Costs

Variable costs are those expenses that change directly in proportion to the level of production or sales activity. In this context, they vary with the level of sales at McDonald's company-owned restaurants. Key components of variable costs include:

• **Food and Packaging** costs, which, at 4,185 million dollars, comprise the materials directly related to the production of food items.
• **Payroll** expenses, totaling 4,006 million dollars, representing the wages and salaries for staff involved in producing sales.
• **General, Selling, and Administrative Expenses**, of which 40% is attributed to variable costs, contributing 6,352.4 million dollars. This includes costs that fluctuate with sales, like commissions and certain promotional activities.

The total of these variable costs is crucial, as they directly impact the profitability by reducing the contribution margin if not controlled.

Fixed Costs

Fixed costs are expenses that remain constant regardless of the level of production or sales. At McDonald's, these costs include portions of the general, selling, and administrative expenses that do not change with sales volume.

To calculate fixed costs, we subtract the variable portion of general, selling, and administrative expenses from the total of these expenses:

\[\text{Fixed Costs} = 15,881 - 6,352.4 = 9,528.6 \text{ million dollars}\]

These expenses are essential to budget for as they provide a stable financial commitment necessary for operating a business, such as rentals, manager salaries, and basic utilities, which don't fluctuate with sales.

Contribution Margin Ratio

The Contribution Margin Ratio is a vital financial metric that indicates the percentage of each sales dollar that remains after variable costs are covered. It represents the portion of sales available to cover fixed costs and generate profit. The formula for calculating the contribution margin ratio is:

\[\text{Contribution Margin Ratio} = \left( \frac{\text{Contribution Margin}}{\text{Sales}} \right) \times 100\]

For McDonald's, this is calculated as:

\[\frac{1,540}{16,083} \times 100 = 9.6\%\]

This percentage shows how much of each dollar is contributing to fixed costs and profit, making it easier to gauge how changes in sales will affect overall profitability.

Income from Operations

Income from Operations reflects the profit a company makes from its core business activities, excluding any financial or investment incomes or expenses. It gives a clear picture of operational efficiency. For McDonald's, the income from operations was reported as 202 million dollars.

Understanding how changes in sales affect this income is crucial. If McDonald's increases its sales by 500 million dollars, with the existing contribution margin ratio of 9.6%, the income from operations would increase as follows:

\[\text{Increase in Income} = 500 \times 0.096 = 48 \text{ million dollars}\]

This calculation helps businesses forecast future profitability based on projected sales increases, assisting them in budgeting and strategic planning.