Question

Morton Company’s contribution format income statement for last month is given below:

Sales (44,000 units × $22 per unit)	$	968,000
Variable expenses		677,600
Contribution margin		290,400
Fixed expenses		232,320
Net operating income	$	58,080

The industry in which Morton Company operates is quite sensitive to cyclical movements in the economy. Thus, profits vary considerably from year to year according to general economic conditions. The company has a large amount of unused capacity and is studying ways of improving profits.

Required:

1. New equipment has come onto the market that would allow Morton Company to automate a portion of its operations. Variable expenses would be reduced by $6.60 per unit. However, fixed expenses would increase to a total of $522,720 each month. Prepare two contribution format income statements, one showing present operations and one showing how operations would appear if the new equipment is purchased. (Round your "Per unit" answers to 2 decimal places.)

	Morton Company Contribution Income Statement Present Proposed Amount Per Unit % Amount Per Unit % % % % % 0 $0.00 0 % 0 $0.00 0 % $0 $0

2.Refer to the income statements in (1) above. For both present operations and the proposed new operations, compute

a. The degree of operating leverage.

	Present Proposed Degree of operating leverage

b. The break-even point in dollar sales.

	Present Proposed Break-even point in dollar sales

c. The margin of safety in both dollar and percentage terms.

	Present Proposed Margin of safety in dollar sales Margin of safety in percentage % %

3. Refer again to the data in (1) above. As a manager, what factor would be paramount in your mind in deciding whether to purchase the new equipment? (Assume that enough funds are available to make the purchase.)

a)	Stock level maintained
b)	Performance of peers in the indstry
c)	Reserves and surplus of the company
d)	Cyclical movements in the economy

4. Refer to the original data. Rather than purchase new equipment, the marketing manager argues that the company’s marketing strategy should be changed. Rather than pay sales commissions, which are currently included in variable expenses, the company would pay salespersons fixed salaries and would invest heavily in advertising. The marketing manager claims this new approach would increase unit sales by 50% without any change in selling price; the company’s new monthly fixed expenses would be $290,400, and its net operating income would increase by 25%. Compute the break-even point in dollar sales for the company under the new marketing strategy.

	New break even point in dollar sales

Answer 1

SOLUTION

1. Contribution format income statement showing the present operations-

	Amount ($)	Per unit ($)	Percentage (%)
Sales	968,000	22.00	100
Less: Variable expense	(677,600)	15.40	70
Contribution margin	290,400	6.60	30
Less: Fixed Expense	(232,320)
Net opearting income	58,080

Contribution format income statement when the new equipment is purchased-

	Amount ($)	Per unit ($)	Percentage (%)
Sales	968,000	22.00	100
Less: Variable expense	(387,200) (8.8*44,000)	(15.40-6.60) = 8.80	40
Contribution margin	580,800	13.20	60
Less: Fixed Expense	(522,720)
Net opearting income	58,080

2. A. Degree of operating leverage = Contribution margin / Operating income

Present-

Degree of operating leverage = $290,400 / 58,080 = 5

Proposed-

Degree of operating leverage = $580,800 / 58,080 = 10

B. Breakeven point in sales dollar = Fixed costs / Contribution margin ratio

Present-

Breakeven point in sales dollar = $232,320 / 30% = $774,400

Proposed-

Breakeven point in sales dollar = $522,720 / 60% = $871,200

C. Margin of safety in dollars = Sales - Breakeven point in dollars

Margin of safety in percentage = Margin of safety in dollars / Sales * 100

Present-

Margin of safety in dollars = $968,000 - $774,400 = $193,600

Margin of safety in percentage = $193,600 / $968,000 * 100 = 20%

Proposed-

Margin of safety in dollars = $968,000 - $871,200 = $96,800

Margin of safety in percentage = $96,800 / $968,000 * 100 = 10%

3. As a manager, the cyclical movements in the economy should be paramount in mind in deciding whether to purchase the new equipment or not becauase the industry in which the company operates is quite sensitive to cyclical movements in the economy.

4. Breakeven point = Fixed expenses / Contribution ratio

= $290,400 / 30% = $968,000