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.

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, $199,000, 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, $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

Given Information for last year:

Selling price per ball = $25

Variable expenses = $15

Direct Labor expense = 60% of variable expense = $15 * 60% = $9 per ball

Other variable expenses = $15 - $9 = $6 per ball

	Per unit	Total (52,000 balls)
Sales Revenue	$25	$1,300,000
Variable expenses:
Direct Labor	9	468,000
Other variable expenses	6	312,000
Total Variable expenses	15	780,000
Contribution Margin	10	520,000
Fixed Expenses		321,000
Net operating Income		199,000

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

Contribution margin ratio = (Contribution margin / Sales Revenue) * 100

= ($780,000 / $1,300,000) * 100 = 60%

Break-even point in balls = Fixed Cost / Contribution Margin per unit = $321,000 / $10 = 32,100 balls

Degree of operating leverage = (Contribution margin / Net Operating Income)

= $780,000 / $199,000 = 3.92

2. Calculation of CM ratio and the break-even point in balls from the revised data i.e. increase on variable expense by $3 per ball:

	Per unit	Total (52,000 balls)
Sales	$25	$1,300,000
Variable expenses:
Direct Labor	12 ($9 + $3)	624,000
Other variable expenses	6	312,000
Total Variable expenses	18	936,000
Contribution Margin	7	364,000
Fixed Expenses		321,000
Net operating Income		43,000

Contribution margin ratio = (Contribution margin / Sales Revenue) * 100

= ($364,000 / $1,300,000) * 100 = 28%

Break-even point in balls = Fixed Cost / Contribution Margin per unit = $321,000 / $7 = 45,858 balls

3. Calculation of number of balls to be sold to earn an net operating income of $199,000:

Required sales quantity = (Fixed cost + Desired profit) / Contribution Per unit

= ($321,000 + $199,000) / $7 = 74,286 balls

4. Calculation of new selling price, if the same contribution margin of 60% is maintained:

Contribution margin ratio = 60%

Variable expense ratio = 100 - 60 = 40%

Revised selling price = Total variable cost per unit / Variabe expense ratio

= $18 / 40% = $45 per ball

Therefore, the revised selling price per ball is $45.

5. Calculation of New CM ratio and the break-even point in balls for automated manufacturing plant:

	Per unit	Total (52,000 balls)
Sales	$25	$1,300,000
Variable expenses:	9 ($15 * 60%)	468,000
Contribution Margin	16	832,000
Fixed Expenses		642,000 ($321,000 * 2)
Net operating Income		190,000

Contribution margin ratio = (Contribution margin / Sales Revenue) * 100

= ($832,000 / $1,300,000) * 100 = 64%

Break-even point in balls = Fixed Cost / Contribution Margin per unit = $642,000 / $16 = 40,125 balls

6. Calculation of number of balls to be sold to earn an net operating income of $199,000 by taking the data in (5):

(a) Required sales quantity = (Fixed cost + Desired profit) / Contribution Per unit

= ($642,000 + $199,000) / $16 = 52,563 balls

(b) Contribution margin income statement:

	Per unit	Total (52,000 balls)
Sales	$25	$1,300,000
Variable expenses:	9 ($15 * 60%)	468,000
Contribution Margin	16	832,000
Fixed Expenses		642,000
Net operating Income		190,000

Degree of operating leverage = (Contribution margin / Net Operating Income)

= $832,000 / $190,000 = 4.18