Nardeb Company is a software producer and sales company. Currently, it pays all sales staff on a fixed base salary. Recently, management has been considering switching sales staff across to an incentive-based reward system. Nardeb’s chief accountant Polly Xu has prepared some summarised numbers (see below) for senior management to consider.
Michael Day comments that he cannot see the difference, as the sales level and profit are unchanged. Xu argues that it is the difference in cost structure that matters. She argues that the entity is better off staying with the current structure, because the increase in profit is greater when sales levels increase than it would be with the incentive rewards.

Required
a. Explain the basis of Polly Xu’s argument.
b. Calculate the contribution margin ratio under each alternative.
c. If sales were to increase by 10 per cent, which alternative would produce the highest increase in profit?
d. Prepare a statement of profit or loss for each alternative.

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Sales Variable costs Contribution margin Fixed costs Profit With fixed rewards $2 500 000 1 500 000 1 000 000 750 000 $ 250 000 With incentive rewards $2 500 000 2 000 000 500 000 250 000 $ 250 000