Question

Morton Company’s contribution format income statement for last month is given below: Sales (47,000 units × $27 per unit) $ 1,269,000 Variable expenses 888,300 Contribution margin 380,700 Fixed expenses 304,560 Net operating income $ 76,140 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 $8.10 per unit. However, fixed expenses would increase to a total of $685,260 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 $486,027; and its net operating income would increase by 20%. Compute the company's break-even point in dollar sales under the new marketing strategy.

Answer 1

1)
Mortan Company
Contribution Income statement
	Present Operation			Proposed Operation
	Amount	Cost per Unit	CM %	Amount	Cost per Unit	CM %
Sales (47,000 units × $27 per unit)	$1,269,000	$27	100.00%	$1,269,000	$27	100.00%
Less:Variable expenses	$888,300	$18.9	70.00%	$507,600	$10.8	40.00%
Contribution margin	$380,700	$8.1	30.00%	$761,400	$16.2	60.00%
Less: Fixed expenses	$304,560			$685,260
Net operating income	$76,140			$76,140
2)a)	Present	Proposed
Operating Leverage = contribution margin/net operating income
Present = $380,700/$76,140	$5
Proposed = $761,400/$76,140		$10
b)
BEP in Dollar = Fixed Costs/ Contribution margin Ratio	Present	Proposed
Present = $304,560/30%	$1,015,200
Proposed = $685,260/60%		$1,142,100
c)
Margin of safety = Total sales – Break-even sales
Present Margin of safety = $1,269,000 – $1,015,200	$253,800
Proposed Margin of safety = $1,269,000 – $1,142,100	$126,900
Margin of safety percent-age = Margin of safety ÷Total sales:
Present Margin of safety % = $1,269,000 – $1,015,200/ $1269000	20.00%
Proposed Margin of safety% = $1,269,000 – $1,142,100/1,269,000	10.00%
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.)
The major factor would be the sensitivity of the company's operations to cyclical movements in the economy because the new equipment will increase the CM ratio, in years of strong economic activity, the company will be better off with the new equipment. However, the company will be worse off with the new equipment in years in which sales drop. The fixed costs of the new equipment will result in losses being incurred more quickly and they will be deeper. Thus, management must decide whether the potential for greater profits in good years is worth the risk of deeper losses in bad year.
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 $486,027; and its net operating income would increase by 20%. Compute the company's break-even point in dollar sales under the new marketing strategy.
New variable expenses:
Profit = (Sales − Variable expenses) − Fixed expenses
New level of net operating income = 1.20 x 76,140	$91,368
New level of sales: $1,269,000 × 1.30	$1,649,700
Fixed cost	$486,027.00
91368 = 1649700 - VE - 486027
Variable Expenses =	1072305
	Amount	CM %
Sales (47,000 x 1.30 units × $27 per unit)	$1,649,700	100.00%
Less:Variable expenses	$1,072,305	65.00%
Contribution margin	$577,395	35.00%
BEP in dollars = Fixed Cost/CM %
BEP in dollars = 486027/35%	$1,388,648.57