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 38,000 of these balls, with the following results:

Sales (38,000 balls)	$	950,000
Variable expenses		570,000
Contribution margin		380,000
Fixed expenses		264,000
Net operating income	$	116,000

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, $116,000, 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, $116,000, as last year?

b. Assume the new plant is built and that next year the company manufactures and sells 38,000 balls (the same number as sold last year). Prepare a contribution format income statement and compute the degree of operating leverage.

Answer 1

Solution 1-a:
Sales Price	25
Less: Variable cost per unit	15
Contribution Margin per unit	10
Contribution Margin ratio	40%
Fixed costs	264000
/Contribution Margin per unit	10
Unit sales to Break even	26400
Solution 1-b:
Total Contribution margin	380000
/ Net operating income	116000
Degree of operating leverage	3.28
Solution 2:
Sales Price	25
Less: New Variable cost per unit (15+3)	18
Contribution Margin per unit	7
Contribution Margin ratio	28%
Fixed costs	264000
/Contribution Margin per unit	7
Unit sales to Break even	37714
Solution 3:
Fixed costs	264000
Add: Target Profit	116000
Total Amount to be earned	380000
/Contribution Margin per unit	7
Number of balls to earn target income	54286
Solution 4:
Required Contribution margin ratio	40%
Therefore, Required Variable Cost ratio	60%
New Variable cost per unit (as computed in solution 2)	18
New Selling Price (Variable cost per unit/ratio)	30
Soltuion 5:
Sales Price	25
Less: New Variable cost per unit [$15*(1-0.40)]	9
New Contribution Margin per unit	16
Contribution Margin ratio	64%
New Fixed costs (Existing fixed cost*200%)	528000
/New Contribution Margin per unit	16
Unit sales to Break even	33000
Solution 6a:
New Fixed costs	528000
Add: Target Profit	116000
Total Amount to be earned	644000
/New Contribution Margin per unit	16
Number of balls to earn target income	40250
Solution 6b:
Northwood company
Contribution margin income statement
Particulars	Amount
Sales (38000*$25)	950000
Variable cost (38000*$9)	342000
Contribution margin	608000
Fixed expenses	528000
Net Operating income	80000
Degree of operating leverage (Contribution / Net Operating income)	7.60