Question

Northwood Company manufactures basketballs. The company has a ball that sells for $42. At present, the ball is manufactured in a small plant that relies heavily on direct labor workers. Thus, variable expenses are high, totaling $32.00 per ball, of which 76% is direct labor cost.

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

Sales (30,000 balls)	$	1,260,000
Variable expenses		960,000
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 $42.00, 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 23.81%, 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 of Part 1 (a):

Contribution Margin Ratio = Contribution Margin / Sales
Contribution Margin Ratio = $300,000 / $1,260,000
Contribution Margin Ratio = 0.2381 or 23.81%

Contribution Margin per Balls = Contribution margin / No. of Balls
Contribution Margin per Balls = $300,000 / 30,000
Contribution Margin per Balls = $10

Break Even Point in Balls = Fixed Expenses / Contribution margin per unit
Break Even Point in Balls = $210,000 / $10
Break Even Point in Balls = $21,000

Answer of Part 1 (b):

Degree of Operating Leverages = Contribution Margin / Net Operating Income
Degree of Operating Leverages = $300,000 / $90,000
Degree of Operating Leverages = 3.33

Answer of Part 2:

Variable Expenses per balls = Variable Expenses / No. of Balls
Current Variable Expenses per Balls = $960,000 / 30,000
Current Variable Expenses per Balls = $32

Expected Variable Expenses per Balls = Variable Expenses per Balls + Increase in Variable Expenses
Expected Variable Expenses per Balls = $32 + $3
Expected Variable Expenses per Balls = $35

Expected Variable Expenses = Expected Variable Expenses per Balls * No. of Balls
Expected Variable Expenses = $35 * 30,000
Expected Variable Expenses = $1,050,000

Contribution Margin = Sales – Total Variable Expenses
Contribution Margin = $1,260,000 - $1,050,000
Contribution Margin = $210,000

Contribution Margin Ratio = Contribution Margin / Sales
Contribution Margin Ratio = $210,000 / $1,260,000
Contribution Margin Ratio = 0.1667 or 16.67%

Contribution Margin per Balls = Contribution margin / No. of Balls
Expected Contribution Margin per Balls = $210,000 / 30,000
Expected Contribution Margin per Balls = $7

Break Even Point in Balls = Fixed Expenses / Contribution margin per unit
Expected Break Even Point in Balls = $210,000 / $7
Expected Break Even Point in Balls = $30,000

Answer of Part 3:

Net Operating Income = Sales – Variable Expense – Fixed Cost
Selling price per Unit = $42
Expected Variable Cost = $35

Let the Number of Units to be sold be “X” units required to earn Net Income of $90,000
$90,000 = ($42 * X) – ($35 * X) - $210,000
$90,000 = $42X - $35X - $210,000
$90,000 + $210,000 = $42X - $35X
$300,000 = $7X
X = $300,000 / $7
X= 42,857

Therefore, the Number of Units to be sold is 42,857 required to earn Net Operating Income of $90,000.

Answer of Part 4:

Required CM Ratio = 23.81%
Expected Variable Cost = $35
Let the Selling Price be “$X”

Contribution Margin Ratio = (Sales –Variable Cost) / Sales * 100
23.81 = ($X - $35) /X*100
23.81X = $100X - $3,500
$3,500 = $100X- $23.81X
$76.19X = $3,500
X = $3,500 / $76.19
X = $45.94

The Selling Price would be $45.94