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) Variable expenses Contribution margin Fixed expenses Net operating income $ 1,000,000 600,000 400,000 265,000 $ 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

Solutions:

1a.

Particulars	Per Unit	For
		40000
Selling Price	25	1000000
Less: Variable Cost	15	600000
Contribution Margin	10	400000
Less: Fixed Cost		265000
Profit		135000

CM Ratio	= Contribution Margin / Selling Price
	40%

Break Even Point - Units

=Fixed Cost / Contribution per unit

=265000/10

26500 units

1.b

Degree of Operating Leverage

=Contribution Margin / Profit

=(10*40000)/135000

2.96

2.

Plugging in the VC increase of $3 per unit
	Per Unit
Selling Price	25
Less: Variable Cost	18
Contribution Margin	7

CM Ratio	= Contribution Margin / Selling Price
	28%

Break Even Points - Units

=Fixed Cost / Contribution per unit

=265000/7

37857 units

3.

Desired Profit ( Units)

=Fixed Cost+Desired Profit / Contribution Per Unit

=(265000+135000)/7

57143 units to be sold

4.

Desired CM Ratio	40%
Variable Cost Ratio	60%
Variable Cost	18
Selling Price Per Unit	= Variable Costs / Variable Cost ratio
	30

New Selling Price is 30 per unit

5.

	Per unit	Amount
Particulars	Per Unit	For
		40000
Selling Price	25	1000000
Less: Variable Cost	9	360000
Contribution Margin	16	640000
Less: Fixed Cost		530000
Profit		110000
CM Ratio	= Contribution Margin / Selling Price
	64%

Break Even Units

=Fixed Cost / Contribution per unit

=530000/16

33125 units