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 56,000 of these balls, with the following results:

Sales (56,000 balls)	$	1,400,000
Variable expenses		840,000
Contribution margin		560,000
Fixed expenses		373,000
Net operating income	$	187,000

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, $187,000, 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, $187,000, as last year?

b. Assume the new plant is built and that next year the company manufactures and sells 56,000 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.

a) Contribution Margin Ratio	= (Contribution Margin / Sales) *100
	= (560000/1400000)*100
	= 40%

Break even point in balls	= Fixed Expenses/ Contribution Per Unit
	= 373000 / 10
	= 37300 balls

Contribution per ball = 560000/56000 = 10 per ball

b) Degree of Operating Leverage = Contribution Margin / Operating Income = 560000/187000 = 2.99

2.

Sale price per ball = 25

Variable cost per ball = (840000/56000) + 3 = 18

Contribution per ball = 25-18 = 7

a) Contribution Margin Ratio	= (Contribution Margin / Sales) *100
	= (7/25)*100
	= 28%

b) Break even point in balls	= Fixed Expenses/ Contribution Per Unit
	= 373000 / 7
	= 53286 balls

3.

No. of balls to be sold	=(Desired Profit + Fixed Expenses)/Contribution per unit
	= (187000+373000)/7
	= 80000 balls

4.

Variable Cost Ratio as per req 1 = 100 - Contribution margin ratio = 100 -40 = 60%

Variable Cost per per req 2 = 18

Selling price to keep same contribution ratio = 18/60% = 30

Contribution = 30-18 = 12

Contribution Margin ratio = (12/30)*100 = 40%

5.

Revised Variable cost = 15*.6 = 9

Revised Contribution = 25-9 =16

Revised Fixed Expenses = 373000*2 = 746000

New CM Ratio = (16/25)*100 = 64%

New Break Even point = 746000 / 16 = 46625 balls

6.

a )No. of balls to be sold = (187000+746000)/16 = 58313 balls

b)

Contribution (56000*16)	896000
Less Fixed expenses	746000
Operating Income	150000

Degree of Operating Leverage = Contribution Margin / Operating Income = 896000/150000 = 5.97