Chapter 5 Problem Northwood Company manufactures basketballs. The company has a
ID: 2594244 • Letter: C
Question
Chapter 5 Problem
Northwood Company manufactures basketballs. The company has a ball that sells for $31. At present, the ball is manufactured in a small plant that relies heavily on direct labor workers. Thus, variable expenses are high, totaling $21.00 per ball, of which 68% is direct labor cost.
Last year, the company sold 30,000 of these balls, with the following results:
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 $31.00, 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, $90,000, 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 32.26%, 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?
b. Assume the new plant is built and that next year the company manufactures and sells 30,000 balls (the same number as sold last year). Prepare a contribution format income statement and Compute the degree of operating leverage.
Sales (30,000 balls) $ 930,000 Variable expenses 630,000 Contribution margin 300,000 Fixed expenses 210,000 Net operating income $ 90,000Explanation / Answer
Northwood Company
CM ratio = contribution margin/sales
Contribution margin = sales – variable cost
Sales price = $31
Variable cost = $21
Contribution margin = 31 – 21 = $10
CM ratio (10/31) x100 = 32.25%
Break-even point in balls = fixed cost/contribution margin
Fixed cost = $210,000
Break-even point in balls = 210,000/10 = 21,000 balls
Operating leverage = contribution margin/operating income
Operating income = $90,000
Contribution margin = $300,000
Operating leverage = 300,000/90,000 = 3.33
CM ratio
CM ratio = contribution margin/sales
Contribution margin = sales – variable cost
Sales price = $31
Variable cost = $24 (increased by $3, $21 + $3 =$24)
Contribution margin = 31 – 24 = $7
CM ratio (7/31) x100 = 22.58%
Break-even point in balls = fixed cost/contribution margin
Fixed cost = $210,000
Break-even point in balls = 210,000/7 = 30,000 balls
Desired units = (fixed cost + target profit)/contribution margin
Contribution margin = $31 – $24 = $7 per ball
Target profit = $90,000
Fixed cost = $210,000
Desired units = (210,000 + $90,000)/7 = 42,857 balls
Variable cost = $24
Sales price =?
Since CM ratio = 31.25%, variable cost ratio = 67.75%
Hence, variable cost represents 67.75% of sales price, then 100% or sales price = $24/67.75% = $35.42 per ball
Hence, the selling price = $35.42
New variable cost = $21 - $21x 32.26% = $14.23
Contribution margin = $31 - $14.23 = $16.77
CM ratio = (16.77/31) x 100 = 54.09%
Fixed cost (doubled) = 2 x $210,000 = $420,000
Break-even point in balls = $420,000/$16.77 =25,044 balls
CM ratio 54.09%
Unit sales to break-even = 25,044 balls
6A. Desired units to earn a target profit of $90,000:
Variable cost (slashed) = $14.23
Fixed cost (doubled) = $420,000
Target profit = $90,000
Contribution margin = $16.77
Desired units = (420,000 + 90,000)/16.77 = 30,411 balls
6B. Contribution margin income statement with the assumptions of new plant built – variable cost reduced and fixed cost doubled, selling price constant:
Northwood Company
Contribution Margin Income Statement
Units
Total
Sales 30,000 balls
$31
$930,000
Variable cost
$14.23
$426,900
Contribution margin
$16.77
$503,100
Fixed cost
$420,000
Net operating income
$83,100
Degree of operating leverage = contribution margin/net operating income
= $503,100/$83,100 = 6.05
Northwood Company
Contribution Margin Income Statement
Units
Total
Sales 30,000 balls
$31
$930,000
Variable cost
$14.23
$426,900
Contribution margin
$16.77
$503,100
Fixed cost
$420,000
Net operating income
$83,100
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