Question

Problem 5-20 CVP Applications: Break-Even Analysis; Cost Structure; Target Sales [LO5-1, LO5-3, LO5-4, LO5-5, LO5-6, LO5-8]

Northwood Company manufactures basketballs. The company has a ball that sells for $34. At present, the ball is manufactured in a small plant that relies heavily on direct labor workers. Thus, variable expenses are high, totaling $24.00 per ball, of which 71% is direct labor cost.

Last year, the company sold 30,000 of these balls, with the following results:

Sales (30,000 balls)	$	1,020,000
Variable expenses		720,000
Contribution margin		300,000
Fixed expenses		210,000
Net operating income	$	90,000

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 $34.00, 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, $90,000, 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 29.41%, 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, $90,000, as last year?

b. Assume the new plant is built and that next year the company manufactures and sells 30,000 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 = (300,000/1,020,000) x 100 = 29.41%
Break even in units =Fixed costs / CM per unit
=210,000 / 10
=21,000 balls
(b) Degree of operating leverage = CM / Net operating Income
=300,000 / 90,000 = 3.33

Working:

Sales Volume	30000
	Total	Per unit
Sales	1020000	34.00
Variable Costs	720000	24.00
Contribution margin	300000	10.00
Fixed Costs	210000	7.00
Net operating income	90000	3.00

2.

2.
(a) CM Ratio = (210,000/1,020,000) x 100 = 20.58%
Break even in units = Fixed costs / CM per unit
=210,000/7
=30,000 balls
(b) Degree of operating leverage = CM / Net operating Income
As there is no net operating prfit ,this ratio cannot be calculated.

Working:

Sales Volume	30000
	Total	Per unit
Sales	1020000	34.00
Variable Costs	810000	27.00
Contribution margin	210000	7.00
Fixed Costs	210000	7.00
Net operating income	0	0.00

3. Number of balls reuired to be sold to earn a

net operating income of 90,000

= (Fixed expenses + target net income) / CM per unit

= (210,000 +90,000) / 7 = 42,857 balls

4. The original CM % = 29.41%.

Variable cost % = 70.59% (100-29.41)

Selling Price = Variabel cost / 70.59% = 27/70.59% = $38.25

5.

Saving in variable cost = 29.41%
	= 29.41% of $24 = $7.06
Revised variable cost = 24.00 - 7.06 = $16.94
Sales Volume	30000
	Total	Per unit
Sales	1020000	34.00
Variable Costs	508200	16.94
Contribution margin	511800	17.06
Fixed Costs	210000	7.00
Net operating income	301800	10.06
New CM ratio = 511,800 / 1,020,000 = 50.17%
New break-even point = 210,000 / 17.06 = 12,310 balls

6. Number of balls reuired to be sold to earn a

net operating income of 90,000

= (Fixed expenses + target net income) / CM per unit

= (210,000 +90,000) / 17.06 = 17,585 balls

Sales Volume	30000
	Total	Per unit
Sales	1020000	34.00
Variable Costs	508200	16.94
Contribution margin	511800	17.06
Fixed Costs	210000	7.00
Net operating income	301800	10.06
Degree of operating leverage = 511,800 / 301,800 = 1.70