Northwood Company manufactures basketballs. The company has a ball that sells for $25.
At present, the ball is manufactured in a small plant that relies heavily on direct labor workers.
Thus, variable expenses are high, totaling 15% per ball, of which 60 percent is direct labor cost.
Last year, the company sold 30,000 of these balls, with the following results:
Sales $750,000
Variable expenses (450,000)
Contribution margin 300,000
Fixed expenses (210,000)
Net operating income$ 90,000
1. Compute the CM ratio and the break-even point in quantity of balls.
2. Compute the degree of operating leverage at last year's sales level.
3. 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 quantity of balls?
4. Refer to the data in (3) 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?
5. Refer again to the data in (3) above. The president feels that the company must raise the selling price of its basketballs.
If Northwood Company wants to maintain the same contribution margin ratio as last year, what selling price per ball must it charge next year to cover the increased labor costs?
6. 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 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 quantity of balls?
7. Refer to the data in (6) above. 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?
8. 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.

Northwood Company

1. Contribution margin ratio = Contribution per unit/Selling price * 100

= $10/$25 * 100

= 40%

Break-even point in quantity of balls = Fixed cost/Contribution margin

= $210,000/$10

= 21,000 balls

Degree of operating leverage = Contribution margin divided by Net operating income (sales minus variable costs and fixed costs)

= $300,000/$90,000

= 3.33

New CM ratio =

Selling price $25

Variable cost 18 (15 + 3)

Contribution $7

Contribution margin ratio = $7/$25 * 100

= 28%

3. Break-even point in quantity of balls = Fixed expenses/contribution margin = $210,000/$7

= 30,000 balls

4. Break-even point in quantity of balls to achieve a target profit of $90,000

= (Fixed cost + Target profit)/$7

= ($210,000 + $90,000)/$7

= $300,000/$7

= 42,857 balls

5. The selling price per ball must increase to:

Variable cost = $15 + $3 = $18 = 60% of selling price

Therefore, new selling price = $18/60%

= $30

6. Selling price = $25

Variable =                9 ($15 * 60%)

Contribution       $16 ($25 - $9)

Fixed expenses = $420,000 (210,000 * 2)

New CM ratio = $16/$25 * 100

= 64%

Break-even point in quantity of balls  = Fixed expenses/Contribution margin

= $420,000/$16

= 26,250 balls

7. To earn target net operating income of $90,000, the quantity of balls will be:

= ($420,000 + $90,000)/$16

= $510,000/$16

= 31,875 balls

8. Contribution Format Income Statement:

Sales Revenue           $750,000 ($25 * 30,000)

Variable expenses       270,000 ($9 * 30,000)

Contribution margin  $480,000

Fixed expenses           420,000

Net operating income $60,000

Degree of operating leverage = Net operating income/Contribution margin

= $60,000/$480,000

= 0.125

Explanation:

a) Data and Calculations:

Selling price per ball = $25

Variable cost per ball = $15 ($450,000/30,000)

Contribution per ball = $10

Fixed expenses = $210,000

Net operating income = $90,000

Sales                             $750,000

Variable expenses       (450,000)

Contribution margin     300,000

Fixed expenses           (210,000)

Net operating income$ 90,000

b) Northwood's degree of operating leverage (DOL) measures how much the operating income of the company will change as a result of a change in its sales.  The DOL ratio, which is a multiple, enables analysts to determine the impact of any change in sales on the earnings or profits of Northwood Company in a given year.

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