Question

Problem 5-29 (Algo) Changes in Cost Structure; Break-Even Analysis; Operating Leverage; Margin of Safety [LO5-4, LO5-5, LO5-7, LO5-8]

Morton Company’s contribution format income statement for last month is given below:

Sales (48,000 units × $23 per unit)	$	1,104,000
Variable expenses		772,800
Contribution margin		331,200
Fixed expenses		264,960
Net operating income	$	66,240

The industry in which Morton Company operates is quite sensitive to cyclical movements in the economy. Thus, profits vary considerably from year to year according to general economic conditions. The company has a large amount of unused capacity and is studying ways of improving profits.

Required:

1. New equipment has come onto the market that would allow Morton Company to automate a portion of its operations. Variable expenses would be reduced by $6.90 per unit. However, fixed expenses would increase to a total of $596,160 each month. Prepare two contribution format income statements, one showing present operations and one showing how operations would appear if the new equipment is purchased.

2. Refer to the income statements in (1). For the present operations and the proposed new operations, compute (a) the degree of operating leverage, (b) the break-even point in dollar sales, and (c) the margin of safety in dollars and the margin of safety percentage.

3. Refer again to the data in (1). As a manager, what factor would be paramount in your mind in deciding whether to purchase the new equipment? (Assume that enough funds are available to make the purchase.)

4. Refer to the original data. Rather than purchase new equipment, the marketing manager argues that the company’s marketing strategy should be changed. Rather than pay sales commissions, which are currently included in variable expenses, the company would pay salespersons fixed salaries and would invest heavily in advertising. The marketing manager claims this new approach would increase unit sales by 30% without any change in selling price; the company’s new monthly fixed expenses would be $422,832; and its net operating income would increase by 20%. Compute the company's break-even point in dollar sales under the new marketing

Answer 1

1. Per unit calculation = amount/number of units = amount/48,000

Current variable expenses = $16.10 per unit. New variable expenses = 16.10 - 6.90 = 9.20 per unit. Total variable expenses = amount per unit*total number of units = 9.20*48,000 = $441,600

% are shown as % of sales.

		Present			Proposed
	Amount	Per unit	%	Amount	Per unit	%
Sales	1,104,000	23.00	100.00%	1,104,000	23.00	100.00%
Variable expenses	772,800	16.10	70.00%	441,600	9.20	40.00%
Contribution margin	331,200	6.90	30.00%	662,400	13.80	60.00%
Fixed expenses	264,960			596,160
Net operating income	66,240			66,240

2. Degree of operating leverage = Contribution margin / Net operating income

Present	331,200 / 66,240	5
Proposed	662,400 / 66,240	10

b. Break even point = Fixed cost / Contribution margin. ratio

Present	264,960 / 30%	883,200
Proposed	596,160 / 60%	993,600

c. Margin of safety = the amount of sales that are above the break-even point

Present	1,104,000 - 883,200	220,800
Proposed	1,104,000 - 993,600	110,400

in % = margin of safety in $/actual sales

Present	220,800 / 1,104,000	20%
Proposed	110,400 / 1,104,000	10%

3. Cyclical movements in the economy

4. Price per unit = $23. New sales = 48,000 units*1.3 = 62,400 units. sales in $ = 62,400*23 = 1,435,200. Fixed expenses = 422,832. Net operating income = 66,240*1.20 = $79,488

Now, sales - variable expenses - fixed expenses = net operating income

or, 1,435,200 - variable expenses - 422,832 = 79,488

or variable expenses = $932,880. Variable costs per unit = 932,880 / 62,400 = $14.95

Thus breakeven in $ sales = [422,832/(23-14.95)]*$23 = $1,208,091