Question

Problem 5-29 Changes in Cost Structure; Break-Even Analysis; Operating Leverage; Margin of Safety [LO5-4, LO5-5, LO5-7, LO5-8] 3.34 points Morton Company's contribution format income statement for last month is given below $ Sales (40,000 units X $27 per unit) Variable expenses Contribution margin Fixed expenses Net operating income 1,000,000 756.000 324,000 259,200 64,500 References 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 $8.10 per unit. However, fixed expenses would increase to a total of $583,200 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 $110.00 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

1. New variable cost per unit = $18.90 - $8.10 = $10.80 per unit

Income Statement	Present		Proposed
	40000 units	Per unit	40000 units	Per unit
Sales Revenue	$   10,80,000	$          27.00	$   10,80,000	$          27.00
Variable Expenses	$     7,56,000	$          18.90	$     4,32,000	$          10.80
Contribution margin	$     3,24,000	$             8.10	$     6,48,000	$          16.20
Fixed Expenses	$     2,59,200		$     5,83,200
Net Operating Income	$        64,800		$        64,800

2.

Income Statement	Present		Proposed
	40000 units	Per unit	40000 units	Per unit
Sales Revenue	$   10,80,000	$          27.00	$   10,80,000	$          27.00
Variable Expenses	$     7,56,000	$          18.90	$     4,32,000	$          10.80
Contribution margin	$     3,24,000	$             8.10	$     6,48,000	$          16.20
Fixed Expenses	$     2,59,200		$     5,83,200
Net Operating Income	$        64,800		$        64,800
Degree of Operating Leverage	5		10
Break Even point (Dollars)	$     8,64,000		$     9,72,000
Margin of Safety (Dollars)	$     2,16,000		$     1,08,000
Margin of Safety (%)	20.00%		10.00%

Degree of Operating Leverage = Contribution Margin / Net Operating Income
Break even point (dollars) = Fixed Expenses / Contribution margin per unit x Sales price
Margin of safety dollars = Actual Sales - Break Even Sales
Margin of Safety (%) = Margin of Safety / Actual Sales x 100

3.
The most important factor is that, since fixed cost is higher in proposed plan, company has to sell more number of units to break even. If the company is able to break even, then proposed plan will be more beneficial as income will increase at higher rate with increase in sales.

4.
Revised Net Operating Income = $64800 x 1.2 = $77760
Contribution Margin = $77760 + 413640 = $491400
Sales units = 40000x 1.3 = 52000

Break Even Sales = $413640 / $9.45 x $27 = $1181844