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 $200,000 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		200,000
Net operating income	$	800,000

Required:

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 $44,000 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 13% reduction in the selling price, combined with a $75,000 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. If the sales manager's ideas are implemented, how much will net operating income increase or decrease over last year? 

6. The president does not want to change the selling price. Instead, he wants to increase the sales commission by $2.30 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 $800,000 net operating income as last year?

Answer 1

According to the requirement of the question, we have to calculate contribution margin ratio, break even points in dollars, net operating income increase, operating leverage and more on....

Requirement 1:- What is the product's Contribution Margin Ratio?

Solution:- Contribution Margin Ratio = Contribution margin / Sales * 100 %

Contribution Margin Ratio = $1,000,000 / $2,000,000 * 100%

Contribution Margin Ratio = 50%

Requirement 2:- Use the Contribution Margin Ratio to determine the break even point in dollar sales.

Solution:- Break-even Point in dollar sales = Fixed Costs / Contribution Margin Ratio

Break-even Point in dollar sales = $200,000 / 50%

Break-even Point in dollar sales = $400,000

Requirement 3:- If this year Sales increase by $44,000 and fixed expenses do not change, how much will be net operating income increase?

Solution:- If the sales increase by $44,000 , then the net operating income = $44,000 * 50%

net operating income = $22,000

Requirement 4 a:- What is the degree of Operating Leverage based on last year's Sales?

Solution:- Operating Leverage = Contribution Margin / Net Operating Income

Operating Leverage = $1,000,000 / $800,000

Operating Leverage = 1.25

Requirement 4 b:- Assume the president accepts 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?

Solution:- % Increase in Net Operating Income = % Increase in Sales * Degree of Operating Leverage

% Increase in Net Operating Income = 11% * 1.25

% Increase in Net Operating Income = 13.75%

Requirement 5:- The sales manager is convinced that a 13% reduction in the selling price, combined with a $75,000 increase in advertising, would increase in this year's unit sales by 25%.

a. If the sales manager is right, what would be the year's net operating income if his ideas are implemented?

Solution:- New Selling price per unit = $80 * (100% - 13%) = $69.6

New Fixed Costs = $200,000 + $75,000 = $275,000

New Sales Volume = ($2,000,000 / $80) * 125% = 31,250 units

Calculation of Net operating Income

Particulars	Amount ($)
Sales (31,250 units * $69.6)	$2,175,000
Less: Variable Expenses (31,250 * $40)	$(1,250,000)
Contribution Margin	$925,000
Less : Fixed Expenses	$(275,000)
Net Operating Income	$650,000

b. If the sales manager ideas are implemented, how much will be the net operating income increase or decrease over last year?

Solution:- Net Operating Income Decreases by $150,000 ($800,000 - $650,000)

Requirement 6 :- The President does not want to change the selling price. Instead, he wants to increase the sales commission by $2.30 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 $800,000 net operating income as last year?

Solution:- If Sales Commission increased by $2.30 per unit then, the new Contribution Margin per unit

= $80 - $40 - $2.30 = $37.7 per unit

New Sales Volume = ($2,000,000 / $80 ) * 125% = 31,250 units

Target operating Income = $800,000

Maximum Fixed Costs = Total Contribution Margin - Target Operating Income

Maximum Fixed Costs = (31,250 units * $37.7) - $800,000

Maximum Fixed Costs = $378,125

Existing Fixed Costs = $200,000

The amount by which advertising can be increase is = $378,125 - $200,000 =$178,125