Question

Northwood Company manufactures basketballs. The company has a ball that sells for $25. At present, the ball is manufactured in a small plant that relies heavily on direct labor workers. Thus, variable expenses are high, totaling $15.00 per ball, of which 60% is direct labor cost.

Last year, the company sold 40,000 of these balls, with the following results:

Sales (40,000 balls)	$	1,000,000
Variable expenses		600,000
Contribution margin		400,000
Fixed expenses		265,000
Net operating income	$	135,000

Required:

1. Compute (a) last year's CM ratio and the break-even point in balls, and (b) the degree of operating leverage at last year’s sales level.

2. Due to an increase in labor rates, the company estimates that next year's variable expenses will increase by $3.00 per ball. If this change takes place and the selling price per ball remains constant at $25.00, what will be next year's CM ratio and the break-even point in balls?

3. Refer to the data in (2) above. If the expected change in variable expenses takes place, how many balls will have to be sold next year to earn the same net operating income, $135,000, as last year?

4. Refer again to the data in (2) above. The president feels that the company must raise the selling price of its basketballs. If Northwood Company wants to maintain the same CM ratio as last year (as computed in requirement 1a), what selling price per ball must it charge next year to cover the increased labor costs?

5. Refer to the original data. The company is discussing the construction of a new, automated manufacturing plant. The new plant would slash variable expenses per ball by 40.00%, but it would cause fixed expenses per year to double. If the new plant is built, what would be the company’s new CM ratio and new break-even point in balls?

6. Refer to the data in (5) above.

a. If the new plant is built, how many balls will have to be sold next year to earn the same net operating income, $135,000, as last year?

b. Assume the new plant is built and that next year the company manufactures and sells 40,000 balls (the same number as sold last year). Prepare a contribution format income statement and Compute the degree of operating leverage.

Answer 1

1(a)	Last year's CM ratio (Contribution Margin ratio) =	Contribution margin	400,000	40%
		Sales	1,000,000
	Break even point in balls =	Fixed cost	265,000	26,500	Balls
		(Revenue per unit - Variable cost per unit)*	10
		*
		Revenue per unit	25
		Less:Variable cost per unit	-15
			10
1(b)	Operating leverage=	Contribution margin	400,000	2.96	Times
		Net operating income	135,000
2	Sales (40000 units@ 25)	A	1,000,000
	Revised variable cost (40000 units @ 18)	B	720,000
	Contribution margin	C = A-B	280,000
	Fixed cost	D	265,000
	Net operating income	C-D	15,000
	Next years CM ratio based on above data	Contribution margin	280,000	28%
		Sales	1,000,000
	Next years' Break even point in balls =	Fixed cost	265,000	37,857	Balls
		(Revenue per unit - Variable cost per unit)*	7
		*
		Revenue per unit	25
		Less:Variable cost per unit	-18
			7
3	Net Operating income (to be maintained)		135,000
	Add:Fixed cost		265,000
	Required Contribution margin	A	400,000
	Revenue per unit		25
	Variable cost per unit		18
	Contribution margin per unit	B	7
	Number of units to be sold to maintain same Net Operating income	(A/B)	57,143
4	CM ratio to be maintained (same as last year)		40%
	Variable cost per unit		18
	Let the selling price per unit		x
	CM ratio =	Contribution margin
		Sales
	or
	CM ratio =	(Selling price per unit - Variable cost per unit)
		Selling price per unit
	or
	40% =	x - 18
		x
	or
	x =	x - 18
		40%
	or
	x =	(x-18)*100
		40
	or
	40x =	100x - 1800
	or
	1800 =	100x - 40x
	or
	1800 =	60x
	or
	x =	1800/60
	x or the new selling price =	30
5	Selling price per unit		25
	New Variable price	15 - (40% of 15)	9
	Fixed expenses	265000*2	530,000
	New CM Ratio=	(Selling price per unit - Variable cost per unit)	25 - 9	64%
		Selling price per unit	25
	New Break even point in balls	Fixed cost	530,000	33,125	balls
		(Revenue per unit - Variable cost per unit)	(25-9)
6(a)	Net Operating income (to be maintained)		135,000
	Add:Fixed cost		530,000
	Required Contribution margin	A	665,000
	Revenue per unit		25
	Variable cost per unit		9
	Contribution margin per unit	B	16
	Number of units to be sold to maintain same Net Operating income	(A/B)	41,563
6(b)	Selling price per unit		25
	Variable cost per unit (if new plant built)		9
	Fixed cost (if new plant builts)		530,000
	Number of balls sold		40,000
	Income statement
	Sales (40000 units @25)		1,000,000
	Less: Variable cost (40000 units @ 9)		360,000
	Contribution margin		640,000
	Less; Fixed cost		530,000
	Net Operating income		110,000
	Operating leverage=	Contribution margin	640,000	5.82	times
		Net operating income	110,000