even po Various CVP Questions: Break-Even Point; Cost Structure: PRO 5-20A les L

ID: 2540933 • Letter: E

Question

even po Various CVP Questions: Break-Even Point; Cost Structure: PRO 5-20A les LO5-1, LO5-3, LOS-4, LOs-5, LOS-6,LOS-8 company has a ball that sells for $25. At present, the Company manufactures basketballs. The Northwood factured in a small plant that relies heavily on direct labor workers. Thus, variable expenses are high, totaling $15 per ball, of which 60% is direct labor cost. Last year, the company sold 30,000 of these balls, with the following results: Sales (30,000 balls) . .450,000 210,000 $ 90,000 Net operating income. Required 2. Due to an increase in labor rates, the company estimates that variable expenses will increase by $3 per 3. Refer to the data in (2) above. If the expected change in variable expenses takes place, how many balls 4 Refer again to the data in (2) above. The president feels that the company must raise the selling price 5, Refer to the original data. The company is discussing the construction of a new, automated 1. Compute (a) the CM ratio and the break-even point in balls, and (b) the degree of operating leverage at last year's sales level. ball next year. If this change takes place and the selling price per ball remains constant at $25, what will be the new CM ratio and break-even point in balls? will have to be sold next year to earn the same net operating income, $90,000, as last year? of its basketballs. If Northwood Company wants to maintain the same CM ratio as last year, what selling price per ball must it charge next year to cover the increased labor costs? manufacturing plant. The new plant would slash variable expenses per ball by 40%, 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, $90,000, as last year? h Assume the new plant is built and that next year the company manufactures and sells 30,000 blls the same number as sold last year), Prepare a contribution format income statement and compute the degree of operating leverage. you were a member of top management, would you have been in favor of constructing the new lant? Explain. c. If

Explanation / Answer

Northwood Company

The question required solution for 5 and 6 only.

Sol5 –

Original data –

Selling price per basketball $25

Variable expenses - $15

Of which direct labor cost is 60%

Fixed expenses - $210,000

Construction of a new plant would,

Decrease variable expenses per ball by 40%, so the revised variable expenses = $15 – 40% of $15 = $9

Fixed expenses would double, so the revised fixed expenses = 2 x $210,000 = $420,000

New contribution margin = sales price – variable cost

= $25 - $9 = $16

Contribution margin ratio = (contribution margin/sales price) x 100

= $16/$25 x 100 = 64%

New break-even point in sales dollars = Fixed cost/contribution margin ratio

= $420,000/64% = $656,250

New break-even point in units = fixed cost/contribution margin

= $420,000/16 = 26,250 balls

6a. determination of the number of balls to be sold next year to earn the same net operating income of $90,000, as last year:

Desired sales level = (fixed cost + target profit)/contribution margin

Fixed cost = $420,000

Target profit = $90,000

Contribution margin = $16 per ball

Desired sales in balls = (420,000 + 90,000)/16= $510,000/16

Hence, desired number of balls to be sold to earn target net income of $90,000 = 31,875

6b. Contribution format income statement for 30,000 balls sold:

Contribution format income statement for 30,000 balls sold:

Sales

$750,000

Variable cost

$270,000

Contribution margin

$480,000

Fixed expenses

$420,000

Net income

$60,000

Degree of operating leverage = contribution margin/net income

= $480,000/$60,000 = 8

No, we will not favor construction of the new plant. Though the construction of the new plant would slash variable expenses by 40%, it would double the fixed expenses to reach $420,000. Also, the degree of operating leverage is high at 8, which indicates that the company relies heavily on fixed expenses.

The net income at original data at sales level of 30,000 balls is $90,000 and the net income if the company sold 30,000 balls under the revised conditions is $60,000, which indicates a decrease of $30,000. This fall in net income is due to presence of high fixed expenses. If the company were to reduce production and sales beyond 30,000 balls, then the company’s net income would reduce further, making the investment in the automated plant a burden. Hence, we do not favor construction of the new automated plant.