Question

Frieden Company's contribution format income statement for last month is shown below:

 

Sales (40,000 units)	$800,000
Variable expenses	$560,000
Contribution marin	$240,000
Fixed expenses	$192,000
Operating income	$48,000

 

Competition is intense, and Frieden Company's profits vary considerably from one year to the next. Management is exploring opportunities to increase profitability.

 

Required:

 

1. Frieden's management is considering a major upgrade to the manufacturing equipment, which would result in fixed expenses increasing by $240,000 per month. However, variable expenses would decrease by $6 per unit. The selling price would not change. Prepare two contribution format income statements, one showing current operations and one showing how operations would appear if the upgrade is completed. Show an Amount column, a Per Unit column, and a Percentage column on each statement. Do not show percentages for the fixed expenses. 

 

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

(a) The degree of operating leverage.

(b) The break-even point in dollars.

 

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

Answer 1

1.

The income statements would be:

 

	Present Amount	Per Unit	%
Sales	$800,000	$20	100%
Variable expenses	$560,000	$14	70%
Contribution margin	$240,000	$6	30%
Fixed expenses	$192,000
Operating income	$48,000

 

*$14 – $6 = $8

**$192,000 + $240,000

 

2.

a.

Degree of operating leverage:

 

Present:

Degree of operating leverage = Contribution margin / Net operating income

Degree of operating leverage = $240,000 / $48,000 

Degree of operating leverage = 5

 

Proposed:

Degree of operating leverage = Contribution margin / Net operating income

Degree of operating leverage = $480,000 / $48,000

Degree of operating leverage = 10

 

b.

Dollar sales to break even:

 

Present:

Dollar sales to break even = Fixed expenses / CM ratio

Dollar sales to break even = $192,000 / 0.30

Dollar sales to break even = $640,000

 

c.

Margin of safety:

 

Present:

Margin of safety = Actual sales - Break-even sales

Margin of safety = $800,000 - $640,000

Margin of safety = $160,000

 

Margin of safety = Margin of safety in dollars / Actual sales

percentage

Margin of safety = $160,000 / $800,000

Margin of safety = 20%

 

Proposed:

Margin of safety = Actual sales - Break-even sales

Margin of safety = $800,000 - $720,000 

Margin of safety = $80,000

 

Margin of safety = Margin of safety in dollars / Actual sales

percentage

Margin of safety = $80,000 / $800,000

Margin of safety = 10%

The income would be $48,000.

 

 

Degree of operating leverage:

Present: 5

Proposed: 10

 

Dollar sales to break even:

Present: $640,000

 

Margin of safety:

Present: $160,000

Proposed: $80,000