Question

Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for $20 per unit. Variable expenses are $8 per unit, and fixed expenses total $180,000 per year. Its operating results for last year were as follows:

Sales	$	400,000
Variable expenses		160,000
Contribution margin		240,000
Fixed expenses		180,000
Net operating income	$	60,000

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 $75,000 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 20%. 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 10% reduction in the selling price, combined with a $30,000 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. Do you recommend implementing the sales manager's suggestions?

6. The president does not want to change the selling price. Instead, he wants to increase the sales commission by $1 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 $60,000 net operating income as last year? Do not prepare an income statement; use the incremental analysis approach.

Answer 1

Concepts and reason

Sales: Sales revenue is the revenue earned by the company by selling its goods or providing its services. The sales revenue is calculated as number of units sold multiplied by the sale price per unit.

Variable costs: Variable costs are the costs which varies with the output of quantity produced that is if the number of units produced increases then the variable cost would also increase.

Fixed costs: Fixed costs are cost which does not varies with the number of units produced and would remain fixed to the extent of producing capacity of the company and any goods produced in excess of capacity would lead to increase in fixed costs. If units are produced below the production capacity of the company still the costs incurred would remain fix and would not change.

Contribution margin: Contribution margin is the income earned by the company after deducting the variable cost from the sales of the company. It is the excess of sales over variable costs and is calculated as sales less variable costs.

Operating income: Operating income is the net income earned from the operating business of the company after deducting operating expenses from the sales revenue.

Fundamentals

Break even point: The break even point is the sales at the company would make no profit nor loss. The break even point is calculated in units and in dollars. At this point the contribution margin would be equal to fixed costs and so there would be no profit or loss for the company. Any units sold or revenue made above this point would lead to profit for the company and any units sold or revenue made below this point would lead to loss for the company.

Degree of operating leverage: Degree of operating leverage tells the percentage change in operating income with percentage in the sales of the company or by how much the operating income would increase or decrease with increase or decrease in the sales.

(1)

Calculation of contribution margin ratio

Thus, the contribution margin ratio is 60%.

Working note

Calculation of contribution margin per unit

(2)

Calculation of break even sales

Thus, break even point in sales dollar is $300,000.

(3)

Calculation of increase in operating income if sales increase by $75,000.

Thus, net operating income would increase by $45,000 if sales increase by $75,000.

(4a)

Calculation of degree of operating leverage

Thus, the degree of operating leverage is 4.

(4b)

Calculation of percentage increase in operating income

Thus, percentage increase in operating income is 80%.

(5a)

Calculation of this year’s operating income

Thus, this year’s net operating income would be $40,000.

Working note

Calculation of units sold last year.

(5b)

Previous year operating income was $60,000 and based on the suggestion current year net operating income would be $40,000 and so there would be decrease in operating income and so changes suggested by sales manager should not be implemented.

Thus, sales manager’s suggestions should not be implemented.

(6)

Calculation of increase in advertising expense

Thus, advertising expense can be increased by $35,000 so that the net operating income remains at $60,000 as last year.

Working note

Calculation of contribution margin per unit

Ans: Part 1

The contribution margin ratio is 60%.

Part 2

Break even point in sales dollar is $300,000.

Part 3

Net operating income would increase by $45,000 if sales increase by $75,000.

Part 4a

Degree of operating leverage is 4.

Part 4b

The percentage increase in operating income is 80% if sales are expected to increase by 20%.

Part 5a

This year’s net operating income would be $40,000.

Part 5b

No, Sales manager’s suggestions should not be implemented.

Part 6

Advertising expense can be increased by $35,000 so that the net operating income remains at $60,000 as last year.