Question

Northwood Company manufactures basketballs. The company has a ball that sells for $38. At present, the ball is manufactured in a small plant that relies heavily on direct labor workers. Thus, variable expenses are high, totaling $28.00 per ball, of which 74% is direct labor cost.

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

Sales (30,000 balls)	$	1,140,000
Variable expenses		840,000
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 $38.00, 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 26.32%, 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

Answer a.

CM Ratio = Contribution Margin / Sales
CM Ratio = $300,000 / $1,140,000
CM Ratio = 26.32%

Contribution Margin per unit = Selling Price - Variable Expenses per unit
Contribution Margin per unit = $38 - $28
Contribution Margin per unit = $10.00

Breakeven Point in balls = Fixed Expenses / Contribution Margin per unit
Breakeven Point in balls = $210,000 / $10.00
Breakeven Point in balls = 21,000

Operating Leverage = Contribution Margin / Net Operating Income
Operating Leverage = $300,000 / $90,000
Operating Leverage = 3.33

Answer b.

Selling Price = $38.00

Variable Expenses per unit = $28.00 + $3.00
Variable Expenses per unit = $31.00

Contribution Margin Ratio = (Selling Price - Variable Expenses per unit) / Selling Price
Contribution Margin Ratio = ($38 - $31) / $38
Contribution Margin Ratio = 18.42%

Contribution Margin per unit = Selling Price - Variable Expenses per unit
Contribution Margin per unit = $38 - $31
Contribution Margin per unit = $7.00

Breakeven Point in balls = Fixed Expenses / Contribution Margin per unit
Breakeven Point in balls = $210,000 / $7.00
Breakeven Point in balls = 30,000

Answer c.

Desired Profit = $90,000

Required Sales in balls = (Fixed Expense + Desired Profit) / Contribution Margin per unit
Required Sales in balls = ($210,000 + $90,000) / $7.00
Required Sales in balls = 42,857

Answer d.

Let new selling price be $X to maintain the same CM Ration as last year.

Contribution Margin Ratio = (Selling Price - Variable Expenses per unit) / Selling Price
26.32% = ($X - $31) / $X
0.2632 * $X = $X - $31
$31 = 1.2632 * $X
$X = $24.54