Question

Morton Company’s contribution format income statement for last month is given below:

Sales (41,000 units × $29 per unit)	$	1,189,000
Variable expenses		832,300
Contribution margin		356,700
Fixed expenses		285,360
Net operating income	$	71,340

The industry in which Morton Company operates is quite sensitive to cyclical movements in the economy. Thus, profits vary considerably from year to year according to general economic conditions. The company has a large amount of unused capacity and is studying ways of improving profits.

Required:

1. New equipment has come onto the market that would allow Morton Company to automate a portion of its operations. Variable expenses would be reduced by $8.70 per unit. However, fixed expenses would increase to a total of $642,060 each month. Prepare two contribution format income statements, one showing present operations and one showing how operations would appear if the new equipment is purchased.

2. Refer to the income statements in (1). For the present operations and the proposed new operations, compute (a) the degree of operating leverage, (b) the break-even point in dollar sales, and (c) the margin of safety in dollars and the margin of safety percentage.

3. Refer again to the data in (1). As a manager, what factor would be paramount in your mind in deciding whether to purchase the new equipment? (Assume that enough funds are available to make the purchase.)

4. Refer to the original data. Rather than purchase new equipment, the marketing manager argues that the company’s marketing strategy should be changed. Rather than pay sales commissions, which are currently included in variable expenses, the company would pay salespersons fixed salaries and would invest heavily in advertising. The marketing manager claims this new approach would increase unit sales by 30% without any change in selling price; the company’s new monthly fixed expenses would be $300,817; and its net operating income would increase by 20%. Compute the company's break-even point in dollar sales under the new marketing

Answer 1

Answer 1.
Morton Company
Contribution Income Statement
	Present Operations
	Total	Per Unit	Percent
Sales - 41,000 Units X $29	1,189,000.00	29.00	100%
Less: Variable Expense	832,300.00	20.30	70%
Contribution Margins	356,700.00	8.70	30%
Less: Fixed Costs	285,360.00
Net Operating Income	71,340.00
Morton Company
Contribution Income Statement
	New Equipment is Purchased
	Total	Per Unit	Percent
Sales - 41,000 Units X $29	1,189,000.00	29.00	100%
Less: Variable Expense	475,600.00	11.60	40%
Contribution Margins	713,400.00	17.40	60%
Less: Fixed Costs	642,060.00
Net Operating Income	71,340.00
Answer 2.
Degree of Operating Leverage = Contribution Margin / Net Operating Income
BEP (in $) = Fixed Cost / Contribution Margin Ratio
Margin of Safety = Sales - BEP
	Present Operations	New Equipment is Purchased
Contribution Margin	356,700.00	713,400.00
Net Operating Income	71,340.00	71,340.00
Degree of Operating Leverage	5.00	10.00
Fixed Costs	285,360.00	642,060.00
Contribution Margin Ratio	30%	60%
BEP (In $)	951,200.00	1,070,100.00
Sales	1,189,000.00	1,189,000.00
BEP (In $)	951,200.00	1,070,100.00
Margin of Safety	237,800.00	118,900.00
Answer 3.
Cyclical Movements in the Economy
Answer 4.
Morton Company
Contribution Income Statement
	Total	Per Unit	Percent
Sales - 53,300 Units X $29	1,545,700.00	29.00	100%
Less: Variable Expense	1,159,275.00	21.75	75%
Contribution Margins	386,425.00	7.25	25%
Less: Fixed Costs	300,817.00
Net Operating Income - $71,340 X 120%	85,608.00
BEP (In $) = Fixed Cost / Contribution Margin ratio
BEP (In $) = $300,817 / 25%
BEP (In $) = $1,203,268