Question

Northwood Company manufactures basketballs. The company has a ball that sells for S25. At present, the ball is manufactured in a small plant that relies heavily on direct labor workers. Thus, variable costs are high, totaling SIS 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) $750,000
Variable expenses 450,000
Contribution margin 300,000
Fixed expenses 210000
Net operating income $90,000

Required:
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.
2. Due to an increase in labor rates, the company estimates that variable costs will increase by S3 per ball next year. If this change takes place and the selling price per ball remains constant at S25, what will be the new CM ratio and break-even point in balls?
3. Refer to the data in (2) above. If the expected change in variable costs 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, 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 costs per ball by 40%, but it would cause fixed costs 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.
c. If you were a member of top management, would you have been in favor of constructing the new plant? Explain.

Answer 1

1A. Compute the CM ratio and the break-even point in balls.

• CM ratio = 2.5
• break even point = 21,000 balls

1B. Compute the degree of operating leverage at last year.

• 31.82%

2. Due to an increase in labor rates, the company estimates that variable expenses will increase by $3 per 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?

• CM ratio = 3.57
• break even point = 30,000 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, last year?

• 42,858 balls

4. 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, what selling price per ball must it charge next year to cover the increased labor costs?

• new price of $28 per ball

5. The company is discussing the construction of a new, automated 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?

• CM = 1.32
• 26,250 balls

6.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?

• 31,875 balls

6.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.

Income Statement

Total revenue $750,000

Variable expenses ($270,000)

Contribution margin $480,000

Fixed expenses ($420,000 )

Net operating income $60,000

Degree of operating leverage = 60.87%

6.c. If you were a member of top management, would you have been in favor of constructing the new plant?

• If you cannot avoid paying the salary raise, then the company needs to carry on the new plant project.

Explanation:

sales price per ball = $25

variable expenses: $15 per unit

• direct labor $9
• other variable costs $6

CM ratio = net sales / CM = $750,000 / $300,000 = 2.5

break even point = total fixed costs / CM per unit = $210,000 / $10 = 21,000 balls

degree of operating leverage = fixed costs / total costs = $210,000 / $660,000 = 31.82%

new CM ratio = net sales / CM = $750,000 / $210,000 = 3.57

break even point = total fixed costs / CM per unit = $210,000 / $7 = 30,000 balls

sales level for $90,000 profit = ($210,000 + $90,000) / $7 = 42,857.14 ≈ 42,858 balls

CM ratio (new plant) = net sales / CM = $750,000 / $570,000 = 1.32

break even point = total fixed costs / CM per unit = $420,000 / $16 = 26,250 balls

sales level for $90,000 profit = ($420,000 + $90,000) / $16 = 31,875 balls