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 40,000 of these balls, with the following results: Sales (40,000 balls) $ 1,000,000 Variable expenses 600,000 Contribution margin 400,000 Fixed expenses 265,000 Net operating income $ 135,000 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?

Answer 1

Solution:

  

  Answer (1):  

Last year's CM ratio:

CM ratio = Contribution margin / sales

= 400,000 / 1,000,000

= 0.4

Last year's CM ratio = 40%

Break Even Point in balls :

BEP = Fixed expenses / Contribution margin per unit

= 265,000 / (25 - 15)   

= 265,000 / 10

  Break even point = 26500

Degree of operating leverage:

Degree of operating leverage = contribution margin / net income

= 4,00,000 / 135,000

  Degree of operating leverage = 2.96

Last year's CM ratio = 40% Break even point = 26,500 Degree of operating leverage = 2.96

Answer (2).

CM ratio for next year:

CM ratio = Contribution margin (from req-2) / Sales (from req-2)

= (10 - 3) / 25

= 7 / 25

= 0.28

CM ratio for next year = 28%

Break even point for next year:

BEP per next year = Fixed expenses / contribution margin per unit (from req 2)

= 265,000 / 7

  Break even point for next year = 37,857.14

CM ratio for next year = 28% Break even point for next year = 37,857.14