Question

Northwood Company manufactures basketballs. The company has a ball that sells for $25. At present, the ball is manufactured in a small plant that relies heavily on direct labor workers. Thus, variable expenses are high, totaling $15.00 per ball, of which 60% is direct labor cost.

Last year, the company sold 48,000 of these balls, with the following results:

Sales (48,000 balls)	$	1,200,000
Variable expenses		720,000
Contribution margin		480,000
Fixed expenses		319,000
Net operating income	$	161,000

Required:

1. Compute (a) last year's CM ratio and the break-even point in balls, and (b) the degree of operating leverage at last year’s sales level.

2. Due to an increase in labor rates, the company estimates that next year's variable expenses will increase by $3.00 per ball. If this change takes place and the selling price per ball remains constant at $25.00, what will be next year's CM ratio and the break-even point in balls?

3. Refer to the data in (2) above. If the expected change in variable expenses takes place, how many balls will have to be sold next year to earn the same net operating income, $161,000, as last year?

4. Refer again to the data in (2) above. The president feels that the company must raise the selling price of its basketballs. If Northwood Company wants to maintain the same CM ratio as last year (as computed in requirement 1a), what selling price per ball must it charge next year to cover the increased labor costs?

5. Refer to the original data. The company is discussing the construction of a new, automated manufacturing plant. The new plant would slash variable expenses per ball by 40.00%, but it would cause fixed expenses per year to double. If the new plant is built, what would be the company’s new CM ratio and new break-even point in balls?

6. Refer to the data in (5) above.

a. If the new plant is built, how many balls will have to be sold next year to earn the same net operating income, $161,000, as last year?

b. Assume the new plant is built and that next year the company manufactures and sells 48,000 balls (the same number as sold last year). Prepare a contribution format income statement and compute the degree of operating leverage.

Answer 1

Part 1 A

Contribution margin ratio = (sales – variable costs)/sales = (1200000-720000)/1200000 = 40%

Break-even point in balls = fixed costs / unit contribution margin

Unit contribution margin = total contribution margin / units sold = 480000/48000= $10 per ball

Break-even point in balls = 319000/10 = 31900 balls

Part 1 B

Degree of operating leverage = contribution margin / net operating income = 480000/161000 = 2.98

Part 2

New variable cost per unit = (720000/48000) + 3 = $18 per ball

Contribution margin ratio = (sales – variable costs)/sales = (25-18)/25 = 28%

Unit contribution margin = 25-18 = $7

Break-even point in balls = fixed costs / unit contribution margin = 319000/7 = 45571 balls

Part 3

Desired sales = (target profit + fixed costs) / unit contribution margin = (161000+319000)/7 = 68571 balls

Part 4

Let selling price per unit = X

Contribution margin = selling price - variable cost

0.40X = X – 18

0.60X = 18

X = $30

Part 5

New variable cost = (720000/48000)*(1-40%) = $9 per ball

New fixed cost = 319000*2 = 638000

Contribution margin = (25-9)/25 = 64%

Break-even point in balls = fixed costs / unit contribution margin = 638000/(25-9) = 39875 balls

Part 6 A

Desired sales = (target profit + fixed costs) / unit contribution margin = (161000+638000)/(25-9) = 49938 balls

Part 6 B

Northwood Company

Contribution Income Statement

Sales (48000*25)	1200000
Variable expense (48000*9)	432000
Contribution margin (48000*16)	768000
Fixed expenses	638000
Net operating income	$130000

Degree of operating leverage = contribution margin / net operating income = 768000/130000 = 5.91