Question

Europa Publications, Inc. specializes in reference books that keep abreast of the rapidly changing political and economic issues in Europe. The results of the company’s operations during the prior year are given in the following table. All units produced during the year were sold. (Ignore income taxes.)

Sales revenue $ 1,850,000

Manufacturing costs: Fixed 478,000

Variable 974,000

Selling costs: Fixed 37,000

Variable 67,000

Administrative costs: Fixed 77,000

Variable 32,000 Required:

1-a. Prepare a traditional income statement for the company. 1-b. Prepare a contribution income statement for the company.

2. What is the firm’s operating leverage for the sales volume generated during the prior year?

3. Suppose sales revenue increases by 12 percent. What will be the percentage increase in net income?

4. Which income statement would an operating manager use to answer requirement (3)?

Answer 1

SOLUTION

1A. Traditional Income statement-

Particulars	Amount ($)	Amount ($)
Sales		1,850,000
Less: Cost of goods sold ($478,000 + $974,000)		1,452,000
Gross margin		398,000
Less: Operating expenses:
Selling expenses ($37,000 + $67,000)	104,000
Administrative expenses ($77,000 + $32,000)	109,000	213,000
Net income		185,000

1B. Contribution income statement

Particulars	Amount ($)	Amount ($)
Sales		1,850,000
Less: Variable Expenses:
Manufacturing costs	974,000
Selling costs	67,000
Administrative costs	32,000	1,073,000
Contribution margin		777,000
Less: Fixed Expenses:
Manufacturing costs	478,000
Selling costs	37,000
Administrative costs	77,000	592,000
Net income		185,000

2. Operating leverage = Contribution margin / Net income

= $777,000 / $185,000

= 4.2

Operating leverage is a measure at a given level of sales, of how a percent change in sales volume will affect profits. The computed operating leverage of 4.2 means that net income grows 4.2 times as fast as its sales.

3. Percentage increase in net income

= Percentage increase in sales revenue * operating leverage factor

= 12% * 4.2 = 50.4%

4. In general, the contribution income statement is preferable for answering the question related to the increase in sales revenue.The reason for this is that the contribution income statement separates the variable and fixed component of the costs.