Question

Morton Company’s contribution format income statement for last month is given below:

Sales (50,000 units × $23 per unit)	$	1,150,000
Variable expenses		805,000
Contribution margin		345,000
Fixed expenses		276,000
Net operating income	$	69,000

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 $621,000 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. (Round your "Per unit" answers to 2 decimal places.)

2.Refer to the income statements in (1) above. For both present operations and the proposed new operations, compute

a. The degree of operating leverage.

b. The break-even point in dollar sales.

c. The margin of safety in both dollar and percentage terms.

3. Refer again to the data in (1) above. 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.)

	Performance of peers in the indstry
	Reserves and surplus of the company
	Cyclical movements in the economy
	Stock level maintained

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 50% without any change in selling price; the company’s new monthly fixed expenses would be $345,000, and its net operating income would increase by 25%. Compute the break-even point in dollar sales for the company under the new marketing strategy.

Answer 1

1. Contribution Margin Income Statement

2.a. Degree of Operating Leverage

Present Degree of Operating Leverage = Contribution Income / Net Income = $345000 / $69000

Present Degree of Operating Leverage = 5

Proposed Degree of Operating Leverage = Proposed Contribution Income / Proposed Net Income = $690000 / $69000

Proposed Degree of Operating Leverage = 10

2b. Break Even Point in Sales

Present Break Even Point = Fixed Cost / Contribution Margin = $276000 / 30%

Present Break Even Point = $920000

Proposed Break Even Point = Proposed Fixed Cost / Proposed Contribution Margin = $621000 / 60%

Proposed Break Even Point = $1035000

2.c. Margin of Safety

Margin Safety in Units

Present Margin of Safety = Current sales - break even sales = 1150000 - $920000

Present Margin of Safety = $230000

Proposed Margin of Safety = Proposed unit sales - Proposed break even sales = $1150000 - $1035000

Proposed Margin of Safety = $115000

Margin of Safety in Percentage terms

Present Margin of Safety = Margin of safety in $ / Current sales = $230000 / $1150000 = 20.00%

Proposed Margin of Safety = Margin of safety in $ / Current sales = $115000 / $1150000 = 10.00%

3. Option C. The manager keep cyclical movements in the economy in mind in deciding to purchase the new equipment

4. Computation of new break even point

Contribution Margin Ratio = (New Net income + Fixed Expenses) / Sales

Contribution Margin Ratio = (69000 * 1.25 + 345000) / $1150000 * 1.50

Contribution Margin Ratio = 25.00%

Break Even Point i= Fixed cost / Contribution Margin ratio

Break Even Point i= $345000 / 25%

Break Even Point sales = $1380000