Question

Morton Company’s contribution format income statement for last month is given below: Sales (45,000 units × $24 per unit) $ 1,080,000 Variable expenses 756,000 Contribution margin 324,000 Fixed expenses 259,200 Net operating income $ 64,800 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 $7.20 per unit. However, fixed expenses would increase to a total of $583,200 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.

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

3. Refer again to the data in (1). 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.)

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 30% without any change in selling price; the company’s new monthly fixed expenses would be $413,640; and its net operating income would increase by 20%. Compute the company's break-even point in dollar sales under the new marketing strategy.

Answer 1

	1.)
		Present	Revised - New Equipment
	Annual Sales Volume	$     10,80,000.00	Rs.                 10,80,000.00
	Units	45000	45000
	Unit Selling Price	$                    24.00	$                                   24.00
	Variable Expenses	$        7,56,000.00	$                       3,24,000.00
	Unit Variable Cost	$                    16.80	$                                     7.20
	Contribution per unit	$                      7.20	$                                   16.80
	Contribution %	30.00%	70.00%
	Total Contribution	$        3,24,000.00	$                       7,56,000.00
	Fixed Cost	$        2,59,200.00	$                       5,83,200.00
	Net operating Income	$           64,800.00	$                       1,72,800.00
	2.)
a.)	Degree of Operating Leverage		=%change in operating income/% change in Sales/Variable cost
	Degree of Operating Leverage		100.0%
	=(16.8-7.2)/(16.8-7.2)
b.	Sales for break even	Present	Revised - New Equipment
A	Fixed Cost	$        2,59,200.00	$                       5,83,200.00
B	% for break even point	30%	70%
A/B	Sales for break even	$        8,64,000.00	$                       8,33,142.86
c.	Margin of safety in dollar sales		=Actual sales - Break even sale
		Present	Revised - New Equipment
	Margin of safety in dollar sales	$        2,16,000.00	$                       2,46,857.14
d.	Margin of safety in %		=MOS/Sales
		Present	Revised - New Equipment
	Margin of safety in %	20.00%	22.86%
	3.)
	As a manager, it would be relevant to see the increase in contribution per unit as there is additional capacity to produce goods. Hence, every unit would add more contribution on sale. Net operating income would be another factor that we would consider apart from contribution.
	4.)
		Revised
	Annual Sales Volume	$     14,04,000.00
	Units	58500
	Unit Selling Price	$                    24.00
	Variable Expenses	$        9,12,600.00
	Unit Variable Cost	$                    15.60
	Contribution per unit	$                      8.40
	Contribution %	35%
	Total Contribution	$        4,91,400.00
	Fixed Cost	$        4,13,640.00
	Net operating Income	$           77,760.00
	Sales for break even	Present
	Fixed Cost	$        4,13,640.00
	% for break even point	35%
	Sales for break even	$     11,81,828.57