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 62,000 of these balls, with the following results:

Sales (62,000 balls)	$	1,550,000
Variable expenses		930,000
Contribution margin		620,000
Fixed expenses		426,000
Net operating income	$	194,000

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?

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, $194,000, 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?

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, $194,000, as last year?

b. Assume the new plant is built and that next year the company manufactures and sells 62,000 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) Contribution margin ratio = contribution margin/sales*100

CM Ratio = 620000/1550000*100

CM Ratio = 40%

Contribution margin per unit = $25 - $15

CM per unit = $10 per unit

Breakeven sales units = fixed cost/contribution margin per unit

= $426000/10

Breakeven sales units = 42600 units

b) Degree of operating leverage = Contribution margin/Net operating income

DOL = $620000/$194000

DOL = 3.19

2. New variable cost per unit = $15 + $3

= $18 per ball

New contribution margin per unit = $25 - $18

= $7 per unit

New contribution margin ratio = $7/$25*100

= 28%

New breakeven point in balls = $426000/$7

= 60857 units

3. Desired sales = (Fixed cost + Desired profit)/Contribution margin per unit

Desired Sales = ($426000 + $194000)/$7

Desired Sales = 88571 units

4. Variable cost per unit = $18

Required contribution margin ratio = 40%

Required variable cost ratio = 60%

New selling price per unit = $18/60%

= $30 per unit

5. New variable cost per unit = $15*60%

= $9 per unit

New contribution margin per unit = $25 - $9

= $16 per unit

New fixed cost = $426000*2

= $852000

New CM Ratio = $16/$25*100

= 64%

New breakeven point = $852000/$16

= 53250 units

6. a) Desired sales = ( Fixed cost + Desired profit)/Contribution margin per unit

Desired sales = ($852000 + $194000)/$16

Desired sales = 65375 units

b).   

Northwood Company
Contribution Margin Income Statement
Net sales (62000*25)	1550000
Less: variable expenses(62000*9)	558000
Contribution	992000
Less: Fixed expenses	852000
Net operating income	140000
Degree of operating leverage =(contribution/net operating income)	7.09