Question

Morton Company’s contribution format income statement for last month is given below: Sales (42,000 units × $26 per unit) $ 1,092,000 Variable expenses 764,400 Contribution margin 327,600 Fixed expenses 262,080 Net operating income $ 65,520 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 $7.80 per unit. However, fixed expenses would increase to a total of $589,680 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 $418,236; 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

Solution

Morton Company

1. Contribution format income statements one showing present operations and one showing how operations would appear if new equipment is purchased:

Morton Company
Contribution Margin Income Statement
	Present Operations	Operations when Equipment is Purchased
Sales	$1,092,000	$1,092,000
Variable Expenses	$764,400	$436,800
Contribution Margin	$327,600	$655,200
Fixed Expenses	$262,080	$589,680
Net Operating Income	$65,520	$65,520

Variable expenses when equipment is purchased –

Variable cost per unit = 764,400/42,000 = $18.20

Per unit variable cost reduced by $7.80

Revised variable cost per unit = 18.20 – 7.80 = $10.40

Revised variable expenses = 42,000 x $10.40 = $436,800

1. A. Degree of operating leverage –

Degree of operating leverage = contribution margin/net operating income

• Present operations

Contribution margin = $327,600

Net operating income = $65,520

Degree of operating leverage = 327,600/65,520 = 5

• Proposed operations

Contribution margin = $655,200

Net operating income = $65,520

Degree of operating leverage = 655,200/65,520 = 10

1. Break-even point in dollar sales –

BEP in dollar sales = fixed cost/contribution margin ratio

• Present operations

Contribution margin ratio = 327,600/1,092,000 = 30%

Fixed cost = $262,080

Break-even sales in dollars = 262,080/30% = $873,600

• Proposed Operations

Contribution margin ratio = 655,200/1,092,000 = 60%

Fixed cost = $589,680

Break-even sales in dollars = 589,680/60% = $982,800

1. Margin of safety in dollar sales and in percentage –

Margin of safety = actual sales – bep sales

Margin of safety percentage = margin of safety sales/actual sales

• Present operations

Actual sales = $1,092,000

Break-even sales = $873,600

Margin of safety = 1,092,000 – 873,600 = $218,400

Margin of safety percentage = 218,400/1,092,000 = 20%

• Proposed operations

Actual sales = $1,092,000

Break-even sales = $982,800

Margin of safety = 1,092,000 – 982,800 = $109,200

Margin of safety percentage = 109,200/1,092,000 = 10%

1. Assuming availability of enough funds, the factors that would be paramount in purchasing the new equipment would be cyclic movements in the economy.

1. Computation of break-even sales in dollars under the new marketing strategy:

Revised sales in units = increase in unit sales by 30% = 42,000 + 30% x 42,000 = 54,600 units

Sales = 54,600 x $26 = $1,419,600

Net operating income increases by 20%

Hence, revised net operating income = $65,520 + 20% 65,520 = $78,624

Given, fixed expenses = $418,236

Hence, desired contribution margin = $496,860

Contribution margin ratio = 496,860/1,419,600 = 35%

Variable expenses = $1,419,600 – 496,860 = $922,740

Variable cost per unit = 922,740/54,600 = $16.90

Hence, reduction in variable cost per unit (under the new marketing strategy) = 18.20 – 16.90 = $1.30

Fixed cost = $418,236

Break-even sales in dollars = 418,236/35% = $1,194,960