Question

Problem 5-29 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 (15,000 units × $30 per unit)	$	450,000
Variable expenses		315,000
Contribution margin		135,000
Fixed expenses		90,000
Net operating income	$	45,000

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 $9 per unit. However, fixed expenses would increase to a total of $225,000 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 $180,000; 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

Part 1 - Contribution margin Income Statements

Particulars	Current situation			Proposed situation
	Amount	Per unit	%	Amount	Per unit	%
Sales	$450000	$30	100%	$450000	$30	100%
Less : Variable expenses	$315000	$21 ($315000/15000)	70%	$180000 ($21-$9)*15000	$12	40%
Contribution margin	$135000	$9	30% (Contribution Margin %)	$270000	$18	60% (Contribution Margin %)
Less : Fixed Expenses	$90000			$225000
Net Operating income	$45000			$45000

Part 2 - Calculation of Break even point, operating leverage, margin of safety

Particulars	Current situation	Proposed situation
Degree of operating Leverage (Contribution Margin/Net Operating income)	$3 ($135000/$45000)	$6 ($270000/$45000)
Break even point in dollars (Fixed Cost/Cotribution margin ratio)	$300000 ($90000/30%)	$375000 ($225000/60%)
Margin of safety in dollars (Sales Revenue - Break Even Sales)	$150000 ($450000 - $300000)	$75000 ($450000 - $375000)
Margin of safety in % (Margin of safety in dollars/sales revenue)*100	33.33% ($150000/$450000)*100	16.67% ($75000/$450000)*100

Part 3 - One Factor which will be of paramount importance should be in the mind of manager on deciding the purchase of equipment - Cyclical movements in the economy

Other factors like Estimation of future income, leverage, forecasting, Break even analysis, cash budget need to be seen.

Part 4 - Calculation of variable expenses

Net Operating Income = ($45000 + 20%) = $54000

Sales Revenue = (15000 + 30%)*$30 = $585000

Fixed Expenses = $180000

Equation :-

Net Opearing Income = Sales - Variable expenses - Fixed expenses

$54000 = $585000 - Variable expenses - $180000

Variable expenses = $351000

Income Statment

Particulars	Amount	%
Sales	$585000	100%
Variable expenses	$351000	60%
Contribution Margin	$234000	40% (Contribution margin ratio)
Fixed expenses	$180000
Net operating Income	$54000
Break Even sales in dollars (Fixed Cost / Contribution margin %)	$450000 ($180000/40%)