Question

Frieden Company's contribution format income statement for last month is shown below:

Sales (46,000 units)	$	920,000
Variable expenses		690,000
Contribution margin		230,000
Fixed expenses		207,000
Operating income	$	23,000

Competition is intense, and Frieden Company’s profits vary considerably from one year to the next. Management is exploring opportunities to increase profitability.

Required:
1.	Frieden’s management is considering a major upgrade to the manufacturing equipment, which would result in fixed expenses increasing by $230,000 per month. However, variable expenses would decrease by $5 per unit. Selling price would not change. Prepare two contribution format income statements, one showing current operations and one showing how operations would appear if the upgrade is completed. Show an Amount column, a Per Unit column, and a Percentage column on each statement.

           

2.	Refer to the income statements in requirement 1 above. For both current operations and the proposed new operations, compute (a) the degree of operating leverage, (b) the break-even point in dollars, and (c) the margin of safety in both dollar and percentage terms.

             

3-a.	Calculate the unit sales per month at which Frieden management will be indifferent between doing the major upgrade to the manufacturing equipment and not doing the upgrade.

            

3-b.	Based on the above analysis, should Frieden proceed with the major upgrade?
	Yes No

3-c.	Why or why not?

          

4-a.	Refer to the original data. Instead of doing the major upgrade to the equipment, management is considering introducing a new advertising campaign that will increase fixed expenses by $26,000 per month. Management believes the new advertisements will increase monthly unit sales by 20%. In this case what would be imapact on operating income.

          

4-b.	Should Frieden proceed with the new advertising campaign?
	Yes No

Answer 1

1.

	Current
Sales Volume	46000
	Per unit	Total	%
Sales	20	920000	100%
Variable expenses	15	690000	75%
Contribution margin	5	230000	25%
Fixed expenses		207000
Net operating income		23000
	Proposed
Sales Volume	46000
	Per unit	Total	%
Sales	20	920000	100%
Variable expenses	10	460000	50%
Contribution margin	10	460000	50%
Fixed expenses		437000
Net operating income		23000

2.

For current operations:
a. Degree of operatin leverage   = Contribution margin / Net operating income
= 230,000 / 23,000= 10
b. Break-even point in dollar sales = Fixed expenses / CM %
= 207,000 / 25% = $828,000
c. Margin of safety = Sales - Break-even sales = $920,000 - $828,000 = $92,000
For proposed operations:
a. Degree of operatin leverage   = Contribution margin / Net operating income
= 460,000 / 23,000= 20
b. Break-even point in dollar sales = Fixed expenses / CM %
= 437,000 / 50% = $874,000
c. Margin of safety = Sales - Break-even sales = $920,000 - $874,000 = $46,000

3-a.

46,000 unit sales is the indifference point between going for upgrade and not going for the upgrade, as the net operating income with or without the upgrade at 46,000 units is the same.

3-b.

No. He shoudl not go for the major upgrade.

3-c.

As there will not be any increase in the net operating income, from the current level he should not go for the upgrade.

4-a.

The net operating income will go up by $20,000 to 443,000 with the advertising campaign, as shown below.

With the advertising campaign, the sales units will
go up by 20% to 55,200 from 46,000.
	Proposed
Sales Volume	55200
	Per unit	Total	%
Sales	20	1104000	100%
Variable expenses	15	828000	75%
Contribution margin	5	276000	25%
Fixed expenses		233000
Net operating income		43000

4-b.

Yes. He should go for the advertising campaign,as this will increase the net operating income by $20,000.