Question

Problem 2-29 (Algo) Changes in Cost Structure; Break-Even Analysis; Operating Leverage; Margin of Safety [LO2-4, LO2-5, LO2-7, LO2-8]

Morton Company’s contribution format income statement for last month is given below:

Sales (42,000 units × $23 per unit)	$	966,000
Variable expenses		676,200
Contribution margin		289,800
Fixed expenses		231,840
Net operating income	$	57,960

The industry in which Morton Company operates is quite sensitive to cyclical movements in the economy. Thus, profits vary considerably from year to year according to general economic conditions. The company has a large amount of unused capacity and is studying ways of improving profits.

Required:

1. New equipment has come onto the market that would allow Morton Company to automate a portion of its operations. Variable expenses would be reduced by $6.90 per unit. However, fixed expenses would increase to a total of $521,640 each month. Prepare two contribution format income statements, one showing present operations and one showing how operations would appear if the new equipment is purchased.

2. Refer to the income statements in (1). For the present operations and the proposed new operations, compute (a) the degree of operating leverage, (b) the break-even point in dollar sales, and (c) the margin of safety in dollars and the margin of safety percentage.

3. Refer again to the data in (1). As a manager, what factor would be paramount in your mind in deciding whether to purchase the new equipment? (Assume that enough funds are available to make the purchase.)

4. Refer to the original data. Rather than purchase new equipment, the marketing manager argues that the company’s marketing strategy should be changed. Rather than pay sales commissions, which are currently included in variable expenses, the company would pay salespersons fixed salaries and would invest heavily in advertising. The marketing manager claims this new approach would increase unit sales by 30% without any change in selling price; the company’s new monthly fixed expenses would be $495,558; and its net operating income would increase by 20%. Compute the company's break-even point in dollar sales under the new marketing strategy.

Answer 1

sales Variable Expenses Contribution Margin Fixed Expense Net Operating Loss Per unit 23.00 16.10 6.90 42000 Units 966000 676200 289800 231840 57960 Answers Reduce the Varaibe cost by 6.90 Fixed cost Will increase to 521640 Units to be porduced 42000 Motron company Contribution Income Statement Present Proposed Amount Per unit % Amount Per unit sales 966000 23.00 100% 966000 23 Variable Expenses 676200 16.10 70% 386400 Contribution Margin 289800 6.90 30% 579600 13.8 Fixed Expense 231840 521640 Net Operating Income 57960 57960 % 9.2 100% 40% 60%

2) Degree of Operating Leverage = DOL DOL = Contiburion Margin/Net Operating Income Present Prososed Degree of Operating Leverage 10 Break Evein Point = Fixed cost / CM Ratio Present Prososed Break Even Point 772800 869400 5 Times Margin of Safety = Actula Sales - BEP Sales Present Margin of Safety 193200 Margin of Safety % 20% Prososed 96600 10% What Factor Would you Consider in youy mind to take the Decision Cyclical Movements in the Economy 54600 495558 69552 1255800 690690 Increase Units sales by 30% Monthly Fixed Cost Operating income Increase by 20% Sales Revneue (Units *Cost) Variable cost = Sales - Fixed cost - Operating Income Contribution Margin CM Ratio = Contibiton Margin Sales / Sales New Break EvenPoint in Dollars = Fixed cost/CM Ratio 565110 45.00% 1101240