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 40,000 of these balls, with the following results: Sales (40,000 balls) $ 1,000,000 Variable expenses 600,000 Contribution margin 400,000 Fixed expenses 265,000 Net operating income $ 135,000 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, $135,000, 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, $135,000, as last year? b. Assume the new plant is built and that next year the company manufactures and sells 40,000 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) CM ratio=Contribution/sales=$10*100/$25=40 %( Refer to note )

Break-Even Point(balls)=Fixed Cost/Contribution per unit= $ 2,65,000/$ 10=26500 unIts( Refer to note )

(b)  Degree of Operating Leverage=Contribution margin/Operating income

                                              =$ 4,00,000/$ 1,35,000=2.96

NOTE:

Particulars	Cost Per unit	Total Cost
Sales	$ 25
Less: Variable Cost
Direct Labour	$ 9
Other Variable Expenses	$ 6
Contribution	$ 10	$ 4,00,000 ($10*40000 units)
Less: Fixed Costs		$ 2,65,000
Net Operating Income		$ 1,35,000

2. CM ratio=Contribution/sales=$7*100/$25=28%( Refer Note)

Break-Even Point(balls)= Fixed Cost/Contribution per unit= $ 2,65,000/$ 7=37858 units Refer Note)

NOTE:

Particulars	Cost Per unit	Total Cost
Sales	$ 25
Less: Variable Cost
Direct Labour	$ 12
Other Variable Expenses	$ 6
Contribution	$ 7	$ 2,80,000 ($7*40000 units)
Less: Fixed Costs		$ 2,65,000
Net Operating Income		$ 15,000

3. Required number of units to be sold=57143 units

Required Net Operating Income=$ 135000

Therefore Required Contribution $ 4,00,000

Number of units required to be sold for this=$ 4,00,000/$7=57143 units

4. Required Selling Price=$30

CM ratio required=40%

Variable cost per unit=$18

Let the selling price= $X, Therefore contribution =X-$18

Therefore ($X-$18)/$X=0.4

0.6X=$18 i.e X=$30