Question

Refer again to the original data of Relax Company for the year ended on December 31, 2019:

Total $

Sales	2,400,000
Less variable costs	1,800,000
Contribution margin	600,000
Less Fixed Costs	250,000
Net Operating income	350,000

During 2019, company’s selling price per unit and variable cost per unit has been $60 and $40 respectively.

Calculate:

a.       A. Assume that in upcoming year of 2020, company management wants to earn a minimum profit of $150,000, how many units will have to be sold by the company to get this target profit?         

b.  B. Compute the company’s degree of operating leverage at the current sales level. What the answer means?          

c.      C.The management is considering using the high quality material for the product. This will increase the variable cost per unit by $5 but the use of high quality materials could increase the sales by 25% of the current sales volume. Prepare a proposed contribution format income statement for the year 2019 and would you suggest that changes be made?   

Answer 1

Note : There is some mistake in question, as it is given, $60 sales price, for which units comes to be $2400000 / 60 = 40000 units, but variable cost is $40 per unit, for which total variable costs has to be $1600000 i.e. 40000 x $40

I have considered $60 and $40 for calculations

a.
Contribution Margin per unit = $60-40 = $20 per unit

Units required = (Fixed Costs + desired profits) / Contribution margin per unit
= ($250000+150000)/20 = 20000 units

b.
Degree of Operating Leverage = Contribution Margin / Operating Income
= $600000 / 350000 = 1.71

This means, for 1% change in sales will lead to 1.71% change in operating income

c.
Present volume = 40000 units

Sales	$   30,00,000	=40000*1.25*60
Less variable costs	$   22,50,000	=40000*1.25*45
Contribution margin	$     7,50,000
Less Fixed Costs	$     2,50,000
Net Operating income	$     5,00,000

Changes should be made, as income increases