Question

Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for $80 per unit. Variable expenses are $40.00 per unit, and fixed expenses total $180,000 per year. Its operating results for last year were as follows: Sales $ 2,080,000 Variable expenses 1,040,000 Contribution margin 1,040,000 Fixed expenses 180,000 Net operating income $ 860,000 Required: Answer each question independently based on the original data:

 1. What is the product's CM ratio?

 2. Use the CM ratio to determine the break-even point in dollar sales.

 3. If this year's sales increase by $52,000 and fixed expenses do not change, how much will net operating income increase?

 4-a. What is the degree of operating leverage based on last year's sales?

 4-b. Assume the president expects this year's sales to increase by 11%. Using the degree of operating leverage from last year, what percentage increase in net operating income will the company realize this year?

 5. The sales manager is convinced that a 15% reduction in the selling price, combined with a $77,000 increase in advertising, would increase this year's unit sales by 25%. 

a. If the sales manager is right, what would be this year's net operating income if his ideas are implemented? 

b. Do you recommend implementing the sales manager's suggestions?

 6. The president does not want to change the selling price. Instead, he wants to increase the sales commission by $2.40 per unit. He thinks that this move, combined with some increase in advertising, would increase this year's sales by 25%. How much could the president increase this year's advertising expense and still earn the same $860,000 net operating income as last year?

Answer 1

Answer

• All working forms part of the answer and explained through ‘working’ equation column.
• General working for last year’s data

		Amount	per unit	Units
A	Sales	2080000	80	26000
B	variable expenses	1040000	40	26000
C=A-B	Contribution margin	1040000	40	26000
D	Fixed expenses	180000
E=C-D	Net Operating Income	860000

• Requirement 1: Products CM ratio

A	Contribution Margin	1040000
B	Sales	2080000
C=A/B	CM ratio	50%

• Requirement 2: Break Even point in Sales dollars

A	Fixed Cost	180000
B	CM ratio	50%
C=A/B	Break Even point in dollar Sales	360000

• Requirement 3: Change in Net operating income if sales increased by $52000

A	Sales increase by	52000
B	CM ratio	50%
C=A x B	Net operating income will increase y	26000

• Requirement 4(a): Degree of Operating leverage

A	Contribution margin	1040000
B	Net Operating Income	860000
C=A/B	Operating leverage (in times)	1.209302326

• Requirement 4(b): % change in Net operating Income

A	Sales increase by	228800
B	CM Ratio	50%
C=A x B	Contribution margin	114400
D	Operating leverage	1.209302326
E=C/D	Increase in Net operating income	94600
F	Old Net Operating Income	860000
G=E/F	% Change	11%

• Requirement 5: What if Unit sales increased by 25% along with advertising cost

		Amount	per unit	Units
A	Sales	2210000	68	32500
B	variable expenses	1300000	40	32500
C=A-B	Contribution margin	910000	28	32500
D	Fixed expenses	180000
E	Advertising	77000
F=C-D-E	Net Operating Income	653000

---Since Net operating income has decreased from $860000 to $653000, Sales manager’s suggestion should not be accepted.

• Requirement 6: President’s View

		Amount	per unit	Units
A	Sales	2600000	80	32500
B	variable expenses	1300000	40	32500
C	Commission	78000	2.4	32500
D=A-B-C	Contribution margin	1222000	37.6	32500
E	Fixed expenses	180000
F	Advertising	x
G=D-E-F	Net Operating Income	860000

Hence, the equation will be ---: D – E – F = G
1222000 – 180000 – x = 860000
1222000 – 180000 – 860000 = x
x = 182000

Therefore, the advertising expense can be increased to $182000 to keep the Net operating Income same as last year’s at $860000