Question

Rex and Knight are the owners of the Modern Processing Company and the Qldway Manufacturing Company, respectively. These companies manufacture and sell the same prod and competition between the two owners has always been friendly. Cost and profit data have been freely exchanged. Uniform selling prices have been set by market conditions. Rey and Knight differ markedly in their management thinking. Operations at Modern are hig mechanized, and the direct labor force is paid on a fixed-salary basis. Oldway uses manual hourly paid labor for the most part and pays incentive bonuses. Modern's salesmen are paid a fixed salary, whereas Qldway's salesmen are paid small salaries plus commissions. Mr. Knigh takes pride in his ability to adapt his costs to fluctuations in sales volume and has frequently chided Mr. Dey on Modern's "inflexible overhead." During 2018, both firms reported the same profit on sales of $100,000. However, when comparing results at the end of 2019, Mr. Knight was startled by the following results: QLRWAY Sales revenue Costs and expenses Net income Return on sales MODERN Year 1 Year 2 $100,000 $120,000 90.000 94.000 S 10,000 S 26.000 10% 21 2/3% Year 1 $100,000 90.000 $ 10.000 10% Year 2 $150,000 130.000 $ 20.000 13 1/3% On the assumption that operating inefficiencies must have existed, Knight and his accountant made a thorough investigation of costs but could not uncover any evidence of costs that were out of line. At a loss to explain the lower increase in profits on a much higher increase in sales volume, they have asked you to prepare an explanation. You find that fixed costs and expenses recorded over the two-year period were as follows: Modern $70,000 each year Oldway $10,000 each year REQUIRED Prepare an explanation for Mr. Knight showing why Oldwax's profits for Year 2 were lower than those reported by Modern despite the fact that dwar's sales had been higher, following the steps below. Show calculations. 1. Redo the income statements emphasizing contribution margin. Calculate breakeven point for each company 3. Calculate operating leverage at revenue level of S100,000, 4 Calculate the amount of sales that Oldwax would have to have had in Year 2 to achieve the profit of S26,000 realized by Modern in Year 2 5. Comment on the relative future positions of the two companies when there are reductions as well as increases in sales volume

Answer 1

As per policy, only four parts of a question are allowed to answer at a time, so answering first four parts here:

1) Contribution Income Statement:
	Modern	Modern	Oldway	Oldway
	Year 1	year 2	Year 1	year 2
Sales rev.	100000	120000	100000	150000
Less:Vari Cost	20000	24000	80000	120000
Contribution	80000	96000	20000	30000
Less:Fixed Cost	70000	70000	10000	10000
Net Income	10000	26000	10000	20000
Contribution margin	80%	80%	20%	20%
2) Break even point: FC/Contri margin
Fixed Costs	70000	70000	10000	10000
Contribution margin	80%	80%	20%	20%
BEP, Sales $	87500	87500	50000	50000
3) Operating leverage : Contribution / Net Income
Contribution	80000	96000	20000	30000
Net Income	10000	26000	10000	20000
OL	8	3.7	2	1.5
4) Sales in Year 2 for Oldway=
FC + Exp. NI / Contri margin =
(10000 + 26000)/20% =
$180,000