Question

Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for $120 per unit. Variable expenses are $60.00 per unit, and fixed expenses total $160,000 per year. Its operating results for last year were as follows:

Sales	$	3,240,000
Variable expenses		1,620,000
Contribution margin		1,620,000
Fixed expenses		160,000
Net operating income	$	1,460,000

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 $55,000 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 15%. 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 11% reduction in the selling price, combined with a $64,000 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 $2.20 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 $1,460,000 net operating income as last year?

Answer 1

• All working forms part of the answer
• Amounts are in $
• Working on given data

	Amount (A)	Per unit (B)	Units (A/B)
Sales	3240000	120	27000
Variable expenses	1620000	60	27000
Contribution margin	$1620000	$60	27000
Fixed expenses	160000
Net operating income	$1460000

• Solutions 1

A	Contribution margin	$1620000
B	Sales	$3240000
C=A/B	CM ratio	50%

• Solution 2

A	Fixed expense	$160000
B	CM ratio	50%
C=A/B	Break Even in Dollar Sales	$320000

• Solution 3

A	Increase in Sale	$55000
B	CM Ratio	50%
C=A x B	Net Operating income will increase by	$27500

• Solution 4(a) and 4 (b)

A	Contribution margin	$1620000
B	Operating Profit	$1460000
C=A/B	Degree of Operating leverage	1.109589
A	Expected increase in Sale	15%
B	Degree of operating leverage	1.109589
C=A x B	Percentage increase in Net operating income	16.64%

• Solution 5 (a) and (b)

	Amount $	Per unit $	Units
Sales	3604500	[120 – 11%] 106.8	[27000 +25%] 33750
Variable expenses	2025000	60	33750
Contribution margin	1579500	46.8	33750
Fixed expenses	[160000+64000] 224000
Net operating income	1355500
Old Net operating income	1460000
Increase/(Decrease) in Income	(104500)

5(b): Since Net operating income is decreasing by $104500, sales manager’s suggestion should not be recommended.

• Solution 6

Maximum Advertising expense can be calculated by calculating prospective Net Operating income and then deducting $1460000 from it.

	Amount $	Per unit $	Units
Sales	4050000	120	[27000+25%] 33750
Variable expenses	2099250	[60+2.2] 62.2	33750
Contribution margin	1950750	57.8	33750
Fixed expenses	160000
Net operating income	1790750
Old Net operating income	1460000
Possible(maximum) increase in advertising expense	$330750