Question

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

Sales (43,000 units × $23 per unit)	$	989,000
Variable expenses		692,300
Contribution margin		296,700
Fixed expenses		237,360
Net operating income	$	59,340

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 $6.90 per unit. However, fixed expenses would increase to a total of $534,060 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 $378,787; and its net operating income would increase by 20%. Compute the company's break-even point in dollar sales under the new marketing strategy.

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 $6.90 per unit. However, fixed expenses would increase to a total of $534,060 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. (Round "Per Unit" to 2 decimal places.)

Answer 1

1

Before purchasing equipment

Contribution formate income statement

Sales (43000×23) 989000

Less variable cost (43000×16.1) 692300

Contribution margin 296700

Less fixed cost 237360

Net operating income 59340

After purchasing the equipment

Sales (43000×23) 989000

Less variable cost (43000 × 9.2) 395600

Contribution margin 593400

Less fixed cost 534060

Net operating income 59340

2

Degree of operating leverage = contribution margin / EBIT (net operating income)

Breakeven point in sales = fixed cost/contribution margin per unit × selling price

Margin of safety in dollar = actual sales - break even sales

Margin of safety in percentage = margin of safety/ actual sales ×100

BEFORE PURCHASING EQUIPMENT

degree of operating leverage = 296700 / 59340 = 5

Break even point in sales = 237360 / 6.9 × 23 = 791200

Margin of safety in dollar = 989000 - 791200 = 197800

Margin of safety in percentage = 197800 / 989000 × 100 = 20%

AFTER PURCHASING THE EQUIPMENT

Degree of operating leverage = 593400 / 59340 = 10

Break even point in sales = 534060 / 13.8 × 23 = 890100

Margin of safety in dollar = 989000 - 890100 = 98900

Margin of safety in percentage = 98900 / 989000 × 100 = 10%

3

if the manager is decided to purchase the new equipment its fixed cost will increase and variable cost will decrease. It will lead to increasing operating leverage and break even sales and decrease margin of safety . Overall if the manager purchase the equipment it will not lead to increase or decrease the operating income

4

30% increase in unit sales = 43000 + 30 % = 55900

Sales = 55900 × 23 = 1285700

Net profit increased by 20% = 59340 + 20% = 71208

Contribution margin per unit = 378787 + 71208 / 55900 = 8.05

Fixed cost = 378787

Break even point in sales = fixed cost / contribution margin per unit × selling price

Break even point in sales = 378787 / 8.05 × 23 = 1072248.57

The above are the detailed calculations for the 4 requirements