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 direc labor cost. Last year, the company sold 44,000 of these balls, with the following results: Sales (44, eee balls) Variable expenses Contribution margin Fixed expenses Net operating income $ 1,180,000 660,000 448,000 317,000 123,eee 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. $123,000, 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 tal, 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 bal 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. $123.000, as last year? b. Assume the new plant is built and that next year the company manufactures and sells 44,000 balls (the same number as sold last year). Prepare a contribution format income statement and compute the degree of operating leverage. Penses per year to double. ifer cakeven point in balls? have to be sold me

Answer 1

Northwood Company Requirement 1 Selling price Variable expenses 100.00% 25 60.00% 15 Contribution margin 40.00% 10 Break even point in units Fixed Cost Contribution per unit = 317000/10 = 31700 balls the degree of operating leverage Contribution Margin Net Operating Income =440000/123000 =3.58 Requirement 2 100.00% Selling price 25 Variable expenses 72.00% 18 Contribution margin 28.00% 7 Break even point in units= Fixed Cost/Contribution per unit =317000 7 =45286 balls Requirement 3 Target Sales in units Fixed cost Target Profit Contribution per unit (317000 123000) / 7 62857 balls

Requirement 4 The contribution margin ratio last year was 40%. If we let P equal the new selling price, then: P $18 +0.40P 0.60P $18 P $18+0.60 P $30 Therefore, to maintain a 40% CM ratio, a $3 increase in variable costs would require a $5 increase in the selling price. Requirement 5 The new CM ratio would be: Selling price 25 100.00% Variable expenses 36.00% Contribution margin 64.00% 16 15 x 60% 9 Break even point in units = Fixed Cost/Contribution per unit =634000 16 = 39625 balls Requirement 6a Target Sales in units Fixed cost Target Profit Contribution per unit (634000+ 123000) /16 47313 balls Requirement 6b This problem illustrates the difficulty faced by some companies. When variable labor costs increase, it is often difficult to pass these cost increases along to customers in the form of higher prices. Thus, companies are forced to automate resulting in higher operating leverage, often a higher break-even point, and greater risk for the company.