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 (43,000 units × $23 per unit)	$	989,000
Variable expenses		692,300
Contribution margin		296,700
Fixed expenses		237,360
Net operating income	$	59,340

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 $6.90 per unit. However, fixed expenses would increase to a total of $534,060 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 $378,787; 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

1.

Morton Company
Contribution Income Statement
	Present Operations			Proposed New Operations
	Amount	Per Unit	%	Amount	Per Unit	%
Sales	989000	23.00	100%	989000	23.00	100%
Variable expenses	692300	16.10	70%	395600	9.20	40%
Contribution margin	296700	6.90	30%	593400	13.80	60%
Fixed expenses	237360			534060
Net operating income	59340			59340

2.

		Present	Proposed
a.	Degree of operating leverage	5	10
b.	Break-even point in dollar sales	$       791,200	$       890,100
c.	Margin of safety in dollars	$       197,800	$           98,900
	Margin of safety percentage	20.00%	10.00%

Working:

Degree of operating leverage = Contribution margin/Net operating income

Break-even point in dollar sales = Fixed expenses/Contribution margin ratio

Margin of safety in dollars = Actual sales - Break-even sales

Margin of safety percentage = Margin of safety/Actual sales

3. Cyclical movements in the economy.

4.

	Amount	%
Sales (43000 x 1.3 x $23)	1285700	100%
Variable expenses ($1285700 - $449995)	835705	65%
Contribution margin ($378787 + $71208)	449995	35%
Fixed expenses	378787
Net operating income ($59340 x 1.2)	71208

New break-even point in dollar sales = Fixed expenses/Contribution margin ratio = $378787/35% = $1082248.571

Kindly round off as required since no instructions have been provided with the question regarding rounding off.