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 52,000 of these balls, with the following results:

Sales (52,000 balls)	$	1,300,000
Variable expenses		780,000
Contribution margin		520,000
Fixed expenses		321,000
Net operating income	$	199,000

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.

1-2. 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?

2. Refer to the data in (1-2) 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, $199,000, as last year?

2-1. Refer again to the data in (1-2) 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?

3. 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?

4. Refer to the data in (3) 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, $199,000, as last year?

b. Assume the new plant is built and that next year the company manufactures and sells 52,000 balls (the same number as sold last year). Prepare a contribution format income statement and Compute the degree of operating leverage.

Answer 1

Solution 1:

Contribution margin ratio = Contribution margin / sales = $520,000 / $1,300,000 = 40%

Contribution margin per unit = $25 - $15 = $10 per unit

Breakeven sales units = Fixed cost / contribution margin per unit = $321,000 / 10 = 32100 units

Degree of operating leverage = Contribution margin / Net operating income = $520,000 / $199,000 = 2.61

Solution 1-2:

New variable cost per unit = $15 + $3 = $18 per ball

new contribution margin per unit = $25 - $18 = $7 per unit

New contribution margin ratio = $7 / $25 =28%

New breakeven point in balls = $321,000 / $7 = 45857 units

Solution 2:

Nos of balls to be sold to earn target income = (Fixed cost + Target profit) / contribution margin per unit

= ($321,000 + $199,000) / $7 = 74286 units

Solution 2-1:

Variable cost per unit = $18 per unit

Required contribution margin ratio = 40%

required variable cost ratio = 60%

New selling price per unit = $18 / 60% = $30 per unit

Solution 3:

New variable cost per unit = $15 * 60% = $9 per unit

New contribution margin per unit = 25- $9 = $16 per unit

New fixed costs = $321,000*2 = $642,000

New CM ratio = $16/$25 = 64%

New breakeven point = $642,000/ $16 = 40125 units

Solution 4a:

Nos of balls to be sold to earn target income = (Fixed cost + Target profit) / contribution margin per unit

= ($642,000 + $199,000) / $16 = 52563 units

Solution 4b:

Northwood Company
Contribution margin income statement
Particulars	Amount
Sales (52000*$25)	$1,300,000.00
Variable cost (52000*$9)	$468,000.00
Contribution margin	$832,000.00
Fixed expenses	$642,000.00
Net Operating income	$190,000.00
Degree of operating leverage (Contribution / Net Operating income)	4.38