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	$	2,000,000
Variable expenses		1,000,000
Contribution margin		1,000,000
Fixed expenses		180,000
Net operating income	$	820,000

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 $59,000 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 10% reduction in the selling price, combined with a $62,000 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 $1.60 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 $820,000 net operating income as last year? Do not prepare an income statement; use the incremental analysis approach.

Answer 1

1.

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.

Contribution margin = Selling price per unit - Variable expenses per unit

= 80 - 40

= $40

Contribution margin ratio = Contribution margin/Sales

= 40/80

= 50%

2.

Break even point (in $) = Fixed cost/Contribution margin ratio

= 180,000/50%

= $360,000

3.

Since contribution margin ratio is 50%, hence variable expenses ratio is 50%

Sales	$	2,059,000
Variable expenses		1,029,500
Contribution margin		1,029,500
Fixed expenses		180,000
Net operating income	$	849,500

Hence, when sales increases by $59,000, net operating income will increase by $29,500 (849,500 - 820,000)

4 a.

Degree of operating leverage = Contribution/Operating income

= 1,000,000/820,000

= 1.22

4b.

Degree of operating leverage = % change in Operating income/% change in sales

1.22 = % change in operating income/11%

Hence, % increase in operating income = 1.22 x 11

= 13.42%

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