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 labour workers. Therefore, the variable costs are high, totaling $15 per ball. Assuming that the new plant is built and the next year the manufactures and sells 30,000 balls (the same number as sold last year). The contribution income is: Sales - 750,000, less: variable expenses - 270,000. Thus, contribution margin is 480,000, less fixed expenses: 420,000. Net Income would be $60,000.  

Degree of operating leverage is 480,000/60,000 = 8.00

If you were a member of top management, would you have been in favor of constructing the new plant? Explain.

Answer 1

Comparison of operating leverage between old production process and new production process

	Old production process	New production process
Sales	$ 750,000	$ 750,000
Less: Variable cost	$ 450,000	$ 270,000
Contribution margin	$ 300,000	$ 480,000
Less: Fixed cost	-	$ 420,000
Operating profit	$ 300,000	$ 60,000
Degree of operating leverage = Contribution margin / Operating profits	$300,000/$ 300,000 =1	$480,000/$ 60,000 = 8

As a top level manager, on the basis of the above calculation , it is not recommend to go ahead for construction of new plant for production, if the sales remain same.

Due to huge amount of fixed expenditures, and limited sales, operating profit gets reduced if new plant has been constructed and used for production.

So, unless sales has been increased to 45,000 units, construction of plant is not suitable for the business. If, the sales increases to 45,000 units by establishment of plant, then it will provide adequate profit which will be equal to profit as per old production process .

Contribution margin = 45,000 X [ $ 25 - $ 9] = $ 720,000

Fixed cost = $ 420,000

Operating profit = $ 720,000 - $ 420,000 = $ 300,000.