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	$	2,160,000
Variable expenses		1,080,000
Contribution margin		1,080,000
Fixed expenses		180,000
Net operating income	$	900,000

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 $42,000 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 12%. 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 $76,000 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 $1.80 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 $900,000 net operating income as last year?

Answer 1

Solution 1:
CM ratio = Contribution margin / Sales = $1,080,000 / $2,160,000 = 50%

Solution 2:
Break even Point in dollar sales = Fixed costs / contribution margin ratio = $180,000 / 50% = $360,000

Solution 3:
If sales increases by $42,000, then increase in net operating income = $42,000 * 50% = $21,000

Solution 4a:
Degree of operating leverage based on last year sales = contribution margin / net operating income
= $1,080,000 / $900,000 = 1.20

Solution 4b:
% increase in net operating income = % increase in sales * Degree of operating leverage
= 12% * 1.20 = 14.40%

Solution 5a:
New selling price per unit = $80 * 87% = $69.60
New Fixed costs = $180,000 + $76,000 = $256,000
New sales volume = ($2,160,000/$80)*125% = 33750 units

Solution 5b:
Decrease in net operating income = $743000 -$900000 = $157,000 decrease

Solution 6:
If sales commission increased by $1.80 per unit then new contribution margin per unit = $80 - $40 - $1.80 = $38.20 per unit
New sales volume = 27000*125% = 33750 units
Target operating income = $900,000
Maximum fixed costs = Total contribution margin - target operating income
= (33750 * $38.20) - $900,000 = $389,250
Existing fixed costs = $180,000
The amount by which advertising can be increase  is = $389,250 - $180,000 = $209,250