Question

Morton Company's contribution format income statement for last month is given below: Sales (50,000 units * $28 per unit) Variable expenses Contribution margin Fixed expenses Net operating income $ 1,400,000 980,000 420,000 336,000 $ 84,000 The industry in which Morton Company operates is quite sensitive to cyclical movements in the economy. Thus, profits vary considerably from year to year according to general economic conditions. The company has a large amount of unused capacity and is studying ways of improving profits. Required: 1. New equipment has come onto the market that would allow Morton Company to automate a portion of its operations. Variable expenses would be reduced by $8.40 per unit. However, fixed expenses would increase to a total of $756,000 each month. Prepare two contribution format income statements, one showing present operations and one showing how operations would appear if the new equipment is purchased. 2. Refer to the income statements in (1). For the present operations and the proposed new operations, compute (a) the degree of operating leverage, (b) the break-even point in dollar sales, and (c) the margin of safety in dollars and the margin of safety percentage. 3. Refer again to the data in (1). As a manager, what factor would be paramount in your mind in deciding whether to purchase the new equipment? (Assume that enough funds are available to make the purchase.) 4. Refer to the original data. Rather than purchase new equipment, the marketing manager argues that the company's marketing strategy should be changed. Rather than pay sales commissions, which are currently included in variable expenses, the company would pay salespersons fixed salaries and would invest heavily in advertising. The marketing manager claims this new approach would increase unit sales by 30% without any change in selling price; the company's new monthly fixed expenses would be $718,200; and its net operating income would increase by 20%. Compute the company's break-even point in dollar sales under the new marketing strategy.

Answer 1

1. Contribution income statement
	Present	Proposed
Sales (50000*28)	1400000	1400000
Variable expense(19.6-8.4)	980000	560000
Contribution margin	420000	840000
Fixed expenses	336000	756000
Net operating income	84000	84000
2. Calculation of following
Contribution margin	420000	840000
Operatin income	84000	84000
Degree of operatin leverage	5	10
Fixed cost	336000	756000
Contribution margin ratio	30%	60%	(Contribution margin/Sales)
BEP ($)	1120000	1260000	(Fixed cost/Contribution ratio)
Current sales	1400000	1400000
Break even sales	1120000	1260000
Margin of safety($)	280000	140000	(current sales-break even sales)
Margin of safety (%)	0.2	0.1	(Margin of safety $/Current sales
3. Assuming enough money is available, cyclical movements should paramount
in the mind of manager on making decision on whether to purchase or not)

4. Increase in unit sales= 50000+30%= 65000
Fixed expenses= 718200
Net operating income= 84000+20%= 100800
Sales (65000*28)	1820000
Variable expense	1001000
Contribution margin	819000
Fixed expenses	718200
Net operating income	100800
Contribution margin ratio= 819000/1820000= 45%
Break even point= 718200/45%= $1596000