Question

Magic Realm, Inc., has developed a new fantasy board game. The company sold 40,000 games last year at a selling price of $65 per game. Fixed expenses associated with the game total $700,000 per year, and variable expenses are $45 per game. Production of the game is entrusted to a printing contractor. Variable expenses consist mostly of payments to this contractor. Required: 1-a. Prepare a contribution format income statement for the game last year. 1-b. Compute the degree of operating leverage. 2. Management is confident that the company can sell 48,800 games next year (an increase of 8,800 games, or 22%, over last year). Given this assumption: a. What is the expected percentage increase in net operating income for next year? b. What is the expected amount of net operating income for next year? (Do not prepare an income statement; use the degree of operating leverage to compute your answer.)

Answer 1

1.a - Contribution format Income Statement for last year :

Sales 2600000 (40000 * 65)
- Variable costs 1800000 (40000 * 45)
Contribution margin 800000
- Fixed costs 700000
Net operating income 100000

1.b - Degree of operating leverage = Contribution margin / Net operating income (EBIT)
  = 800000 / 100000
= 8

2.a -
Sales 3172000 (48800 * 65)
- Variable costs 2196000 (48800 * 45)
Contribution margin 976000
- Fixed costs 700000
Net operating income 276000

Hence, the expected percentage increase in net operating income for the next year
= (276000 - 100000) / 100000 * 100 = 176%

2.b -
Degree of operating leverage = % (of future) change in Net operating income (EBIT) / % (of future) change in sales
8 = % (of future) change in Net operating income (EBIT) / 22
Hence, the expected percentage increase in net operating income for next year is 176.

Therefore, the net operating income for the next year will be = 100000 + (100000*176/100) = 276000