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 36,000 of these balls, with the following results:

Sales (36,000 balls)	$	900,000
Variable expenses		540,000
Contribution margin		360,000
Fixed expenses		263,000
Net operating income	$	97,000

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, $97,000, 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, $97,000, as last year?

b. Assume the new plant is built and that next year the company manufactures and sells 36,000 balls (the same number as sold last year). Prepare a contribution format income statement and compute the degree of operating leverage.

Answer 1

Answer-

1)CM ratio = contribution /sales

= 360,000/ 900.000

= .40 or 40%

contribution per ball = price -variable cost

         = 25-15

           = 10

Break even point(balls) =fixed cost /contribution per ball

=263,000/10

=26,300 balls

Degree of operating leverage =contribution /net operating income

       =360,000/ 97,000

        = 3.71

2.

Labor cost is 60% of Variable expenses	324,000
Cost per ball ($324,000/36,000)	9
Increase in price	3
Total new price	12
Total labor cost (12*36,000)	432,000
Other variable expenses (same as last period - 540,000*40%)	216,000
Total Variable expenses	648,000
Contribution Margin ($900,000-$648,000)	252,000

Contribution margin rato = 252,000/ 900,000 = 28%

Since the new contribution margin is the same as total fixed expenses, the break even sales is at 48,000 balls

3. Expected Net Operating Income = 97,000

    +Total fixed expenses = 263,000

Expected Contribution margin 360,000

Expected sales = (Expected CM/ CM Ratio*100%) = 360,000*100%/28% = 1,285,714

Selling price per unit = $35

Number of balls to be sol = 1,285,714/25 = 51,429

4.

Total Variable expenses	648,000
CM Ratio of current year	40%
Variable expenses ratio	60%
Expected sales (648,000*100%/60%)	1,080,000
Selling price per unit (1,080,000/36,000)	30

5.

	Original	New
Sales	900,000	900,000
Variable expenses [540,000-(540,000*40%)]	540,000	324,000
Contribution margin	360,000	576,000
Fixed expenses [263,000+263,000]	263,000	526000
Net Operating income	97,000	50,000

CM Ratio = 576,000/ 900,000 = 64%

Break even sales in units = Total fixed expenses / CM per unit = 526,000/16= 32,875

CM Per unit = 576,000 / 36,000 = 15.40

6.a Expected Net operating Income = 97,000

+Total fixed expenses = 526,000

Expected Contribution margin = 623,000

CM Ration = 64%

Expected sales = (Expected CM/ CM Ratio*100%) = (623,000*100%/64%) =973,438

Expected sales in uniits = 973,438/ 25 = 38,938 balls

b.

Northwood Company
Contribution Income statement
Sales	900,000
Variable expenses	324,000
Contribution margin	576,000
Fixed expenses	526,000
Net Operating income	50,000