Question

Vice President for Sales and Marketing Sam Totter is trying to plan for the coming year in terms of production needs to meet the sales demand. He is also trying to determine ways in which the company’s profits might be increased in the coming year.

Instructions (Do all parts):

Northern Illinois Manufacturing markets a simple water control and timer that it mass-produces. During last year, the company sold 701,000 units at an average selling price of 4.20 per unit. The variable expenses were $1,857,650 and the fixed expenses were $646,450.

1. Northern Illinois’ management believes that increased advertising would increase unit sales by 10%. If management wants to increase its operating income by $50,000, how much could the company spend on additional advertising to reach its goal?
2. Using last year’s data as the starting point, assume the company can increase sales by 5% by just continuing its current marketing program. What would the company’s net operating income by next year using the DOL?

Answer 1

Answer)

Calculation of amount of advertising spend

Proposed sales revenue = Number of units expected to be sold X Selling price per unit

                                           = 771,100 units X $ 4.20 per unit

                                           = $ 3,238,620

Proposed variable cost = Number of units expected to be sold X Variable cost per unit

                                           = 771,100 units X $ 2.65 per unit

                                           = $ 2,043,415

Proposed Fixed cost = Existing fixed cost + proposed Advertising cost

                                     = $ 646,450 + proposed advertising cost

Target Income = Current income + Expected increase in income

                           = $ 440,100 + $ 50,000

                           = $ 490,100

Fixed cost = Sales – variable cost – Operating income

$ 646,450 + Advertising cost = $ 3,238,620 - $ 2,043,415 - $ 490,100

Advertising cost = $ 58,655

Therefore the company can spend $ 58,655 on advertising to reach its goal of increase in net operating income by $ 50,000.

Working Note:

Calculation of variable cost per unit

Variable cost per unit = Total variable cost/ number of units sold

                                         = $ 1,857,650/ 701,000 units

                                        = $ 2.65 per unit

Calculation of Number of units sold proposed to be sold after spending on advertising:

Number of units proposed to be sold = Number of units sold at present X 110%

                                                                     = 701,000 X 110%

                                                                     = $ 771,100

Calculation of Present operating Income

Operating Income = Sales – variable costs – fixed costs

                                 = (701,000 units X $ 4.20 per unit) - $ 1,857,650 - $ 646,450

                                = $ 440,100

Answer 2)

Calculation of net operating income of the company with 5% increase in sale

Percentage increase Operating Income = percentage increase Sales revenue X Degree of operating leverage

                                                                                = 5% X 2.47 times

                                                                                = 12.35%

Proposed net operating Income = Current net operating income X 112.35%

                                                            = $ 440,100 X 112.35%

                                                            = $ 494,452

Therefore expected net operating income of the company will be $ 494,452.

Working Note:

Calculation of degree of operating leverage

Degree of Operating leverage = Contribution margin/ Operating Income

                                                        = (Sales – variable expenses)/ Operating Income

                                                        = ($ 2,944,200 - $ 1,857,650)/ $ 440,100

                                                        = $ 1,086,550/ $ 440,100

                                                       = 2.46887 times or 2.47 times (rounded off)