Question

On the sheet tab labeled SOLUTION 3, use the DATA FOR SOLUTION 3 on the sheet tab labeled DATA to: H Compute the new contribution margin ration Compute the new break even in number of 2.6 gallon fish tanks Compute the number of 2.6 gallon fish tanks that will have to be sold next year to maintain the current operating income On the sheet tab labeled SOLUTION 4, use the DATA FOR SOLUTION 3 and DATA FOR SOLUTION 4 on the sheet tab labeled DATA to: K Assume the company sells the same number (10,000) of 2.6 gallon fish tanks as last year and prepare a contribution format income statement 1 Compute the degree of operating leverage M Explain whether or not you would be in favor of building the new plant

Answer 1

The existing net income statement

	Quantity	Rate	Value
Sales Revenue	40000	37.5	1500000
Less: Expenses
Variable cost	40000	22.5	900000
Fixed Cost			480000
Profit			120000

New variable cost estimated = 25.5 per unit.

New plant will reduce variable cost to 22.5 * 0.6 = 13.5 per unit.  

Fixed cost increase by 90%. Hence fixed cost will increase to 480000 * 1.9 = 912000

New Contribution margin ratio = (37.5 - 13.5) / 37.5 = 64%

New break even = 912000 / 24 = 38000 units

New units that should be sold next year to maintain same operating income = (912000 + 120000) / 24 = 43000 units.

New plant income statement at 40000 units sales
	Quantity	Rate	Value
Sales Revenue	40000	37.5	1500000
Less: Expenses
Variable cost	40000	13.5	540000
Fixed Cost			912000
Profit			48000

New plant income statement at 40400 units sold
	Quantity	Rate	Value
Sales Revenue	40400	37.5	1515000
Less: Expenses
Variable cost	40400	13.5	545400
Fixed Cost			912000
Profit			57600

Degree of operating leverage = ((57600 - 48000)/48000) / (1515000 - 1500000) / 1500000 = 20

I will be in favour of building the new plant if the future years' sales are expected to be more and there will be good demand for the product in future.  

Assuming that sales will be only 40000 units,

Existing plant income statement at 40000 units sold in next year
	Quantity	Rate	Value
Sales Revenue	40000	37.5	1500000
Less: Expenses
Variable cost	40000	25.5	1020000
Fixed Cost			480000
Profit			0

It makes sense in building the new plant.