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 58,000 of these balls, with the following results: Sales (58,000 balls) $ 1,450,000 Variable expenses 870,000 Contribution margin 580,000 Fixed expenses 374,000 Net operating income $ 206,000 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, $206,000, 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, $206,000, as last year? b. Assume the new plant is built and that next year the company manufactures and sells 58,000 balls (the same number as sold last year). Prepare a contribution format income statement and Compute the degree of operating leverage.

Answer 1

Sales	1450000
Less: variable cost	870000
Contribution margin	580000
Less: fixed cost	374000
Net operating income	206000
Answer 1
Contribution margin	580000
Sales	1450000
Contribution margin ratio (Contribution margin / Sales)	40%
Fixed cost	374000
Contribution per ball (selling price per ball - variable cost per ball) (25-15)	10
Break-even point in balls (fixed cost / contribution per ball)	37400
Contribution margin	580000
Net operating income	206000
Degree of operating leverage (Contribution margin / Net operating income)	2.815534

Due to an increase in labor rates, the company estimates that next year's variable expenses will increase by $3.00 per ball
Sales	1450000
Less: variable cost (15+3 =18) (18*58000)	1044000
Contribution margin	406000
Less: fixed cost	374000
Net operating income	32000
Answer 2
Contribution margin	406000
Sales	1450000
Contribution margin ratio (Contribution margin / Sales)	28%
Fixed cost	374000
Contribution per ball (selling price per ball - variable cost per ball) (25-15)	10
Break-even point in balls (fixed cost / contribution per ball)	37400
Contribution margin	406000
Net operating income	32000
Degree of operating leverage (Contribution margin / Net operating income)	12.6875
Answer 3
Desired net operating income	206000
Add: fixed cost	374000
Total contribution required to earn desired net operating income	580000
Contribution per ball (selling price per ball - variable cost per ball) (25-18)	7
Number of ball sold in next year (Total contribution required to earn desired net operating income / contribution per ball)	82857
Answer 4
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
Contribution margin ratio	40%
Variable cost to sales ratio (1-40%)	0.6
Variable cost per ball	18
Selling price per ball (18/60%)	$    30.00

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