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 56,000 of these balls, with the following results:

Sales (56,000 balls)	$	1,400,000
Variable expenses		840,000
Contribution margin		560,000
Fixed expenses		373,000
Net operating income	$	187,000

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.

	CM Ratio % Unit sales to break even balls Degree of operating leverage

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?

	CM Ratio % Unit sales to break even balls

3. Refer to the data in (2) above. If the expected change in variable expenses takes place, how many balls will have to be sold next year to earn the same net operating income, $187,000, as last year?

4. Refer again to the data in (2) above. The president feels that the company must raise the selling price of its basketballs. If Northwood Company wants to maintain the same CM ratio as last year (as computed in requirement 1a), what selling price per ball must it charge next year to cover the increased labor costs?3. Refer to the data in (2) above. If the expected change in variable expenses takes place, how many balls will have to be sold next year to earn the same net operating income, $187,000, as last year?

5. Refer to the original data. The company is discussing the construction of a new, automated manufacturing plant. The new plant would slash variable expenses per ball by 40.00%, but it would cause fixed expenses per year to double. If the new plant is built, what would be the company’s new CM ratio and new break-even point in balls?

6. Refer to the data in (5) above.

a. If the new plant is built, how many balls will have to be sold next year to earn the same net operating income, $187,000, as last year?

b. Assume the new plant is built and that next year the company manufactures and sells 56,000 balls (the same number as sold last year). Prepare a contribution format income statement and compute the degree of operating leverage.

Answer 1

1.(a)Last year's contribution margin ratio is computed as:

CM ratio=((Selling price per unit-variable cost per unit)/selling price per unit)*100

CM ratio=(($25-$15)/$25)*100

CM atio=($10/$25)*100

CM ratio=40%

Break even point in balls=Total fixed cost/Contribution per unit

Cobtribution per unit=$25-$15=$10

Break even point in balls=373,000/10

Break even point in balls=37,300 balls

(b) Degree of operating leverage =Total contribution/Net income

Degree of operating leverage=560,000/187,000

Degree of operating leverage=2.99

2.Revised CM ratio is computed as:

Revised variable cost per unit=$15+$3=$18

Contribition per unit=Selling price per unit-Variable vost per ubit

Cobtribution per unit=$25-$18=$7

CM ratio= (Contribution per unit/Selling price per unit)*100

CM ratio=($7/$25)*100
CM ratio=28%
Break even point in balls=Total fixed cost/Revised contribution

Break even point in balls=373,000/7

Break even point in balls=53,285 balls

3.Required sales in balls=Desired contribution/Contribution per unit

Required sales in balls=560,000/7

Required sales in balls=80,000 balls

4.Revised selling price per unit is computed as:
Revised variable cost per unit

Total variable cost=18*56,000=1,008,000

Contribution margin ratio as calculated in 1a is 40%
Variable cost ratio to sales =100%-40%=60%

Expected sales=(1,008,000*100%)/60%

Expected sales=1,680,000
Revised selling price per unit=1,680,000/56,000
Revised selling price per unit=$30 per unit