The Company is planning its annual budget and is deciding whether to increase its discretionary marketing spending. Marketing is considered a discretionary fixed cost because it does not vary with production or sales in the short term. The company has the following options:

Maintain the current marketing budget of $1,500,000.
Increase the marketing budget to $2,000,000, with an expected 20% increase in sales.
Reduce the marketing budget to $1,000,000, with an expected 10% decrease in sales.

Current financial data:

Annual Sales Revenue: $10,000,000
Contribution Margin: 40%
Fixed Operating Costs (excluding marketing): $2,000,000

Which option should the Company choose to maximize profitability, assuming the sales expectations hold true?

Question

The Company is planning its annual budget and is deciding whether to increase its discretionary marketing spending. Marketing is considered a discretionary fixed cost because it does not vary with production or sales in the short term. The company has the following options:

Maintain the current marketing budget of $1,500,000.
Increase the marketing budget to $2,000,000, with an expected 20% increase in sales.
Reduce the marketing budget to $1,000,000, with an expected 10% decrease in sales.

Current financial data:

Annual Sales Revenue: $10,000,000
Contribution Margin: 40%
Fixed Operating Costs (excluding marketing): $2,000,000

Which option should the Company choose to maximize profitability, assuming the sales expectations hold true?

BlackTom AI · Accepted Answer

We need to compare profitability under each option by considering how revenue, contribution margin, and fixed costs change.
Option 1: Maintain the current marketing budget of $1,500,000. With fixed operating costs excluding marketing at $2,000,000, total fixed costs = 2,000,000 + 1,500,000 = 3,500,000. Current revenue is $10,000,000 and the contribution margin is 40%, so the contribution (gross margin available to cover fixed costs) is 0.40 × 10,000,000 = 4,000,000. Profit is contribution minus fixed costs: 4,000,000 − 3,500,000 = 500,000. This establishes a baseline profitability.
Option 2: Increase marketing budget to $2,000,000 with an expected 20% increase in sales. New revenue = 10,000,000 × 1.20 = 12,000,000. Contribution = 0.40 × 12,000,000 = 4,800,000. Total fixed costs = 2,000,000 (other fixed costs) + 2,000,000 (marketing) = 4,000,000. Profit = 4,800,000 − 4,000,000 = 800,000. The higher revenue, aided by the same CM ratio, more than offsets the higher marketing expense, leading to greater profitability than the baseline.
Option 3: Reduce marketing budget to $1,000,000 with an expected 10% decrease in sales. New revenue = 10,000,000 × 0.90 = 9,000,000. Contribution = 0.40 × 9,000,000 = 3,600,000. Total fixed costs = 2,000,000 + 1,000,000 = 3,000,000. Profit = 3,600,000 − 3,000,000 = 600,000. Here, lower marketing spend reduces fixed costs, but the revenue drop lowers contribution, resulting in profit less than Option 2 and slightly higher than the baseline but not optimal.
Option 4: Increase the marketing budget to $2,000,000 (without explicitly stated sales change beyond what Option 2 provides). If we treat this as the same revenue effect as Option 2 (20% increase in sales), the calculation mirrors Option 2 with profit of 800,000. If the sales impact is different, profit would adjust accordingly, but using the stated assumption from the other option yields the same result as Option 2.
Overall comparison: Option 2 yields the highest derived profit (800,000) under the given sales impact assumptions, Option 3 yields 600,000, Option 1 yields 500,000, and Option 4, under the same sales assumption as Option 2, also points to the same profitability as Option 2. The core idea is that profitability depends on whether the incremental sales at a given CM ratio more than compensate for the additional fixed marketing cost.

2025FA_IMC_402-0_SEC20 Practice Exam for Final

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