Question

Exercise 5-15 Operating Leverage [LO5-1, LO5-8]

Magic Realm, Inc., has developed a new fantasy board game. The company sold 36,800 games last year at a selling price of $62 per game. Fixed expenses associated with the game total $644,000 per year, and variable expenses are $42 per game. Production of the game is entrusted to a printing contractor. Variable expenses consist mostly of payments to this contractor.

Required:

1-a. Prepare a contribution format income statement for the game last year.

1-b. Compute the degree of operating leverage.

2. Management is confident that the company can sell 44,528 games next year (an increase of 7,728 games, or 21%, over last year). Given this assumption:

a. What is the expected percentage increase in net operating income for next year?

b. What is the expected amount of net operating income for next year? (Do not prepare an income statement; use the degree of operating leverage to compute your answer.)

Answer 1

1-a.

Magic Realm Inc.
Contribution Format income statement for last year
Sales - units	36800
	Per unit	Total
Sales Revenue	62	2281600
Variable expenses	42	1545600
Contribution margin	20	736000
Fixed Expenses		644000
Net operating income		92000

1-b.

Degree of operating leverage	8.00
(Contribution margin / net operating income)

2.a.

Percentage increase in net operating income

168%

Working:

Increase in sales volume	21%
Increase in contribution margin	21%
Increase in contribution margin - Dollars	154560
Increase in net operating income - Dollars	154560
Percentage increase in net operating income	168%
(154,560 / 92,000)

2.b.

Expected net operatin income = $92,000 + $154,560 = $246,560.