Frieden Company's contribution format income statement for the most recent month is given below:
Sales (46,000 units) $ 966,000
Variable expenses 676,200
Contribution margin 289,800
Fixed expenses 231,840
Net operating income $ 57,960
The industry in which Frieden 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 on the market that would allow Frieden Company to automate a portion of its operations. Variable expenses would be reduced by $6.30 per unit. However, fixed expenses would increase to a total of $521,640 each month. Prepare two contribution format income statements, one showing present operations and one showing how operations would appear if the new equipment is purchased. (Input all amounts as positive values except losses which should be indicated by minus sign. Round your "Per unit" answers to 2 decimal places. Omit the "$" and "%" signs in your response.)
Present
Proposed
Amount Per Unit % Amount Per Unit %
$ $ % $ $ %
$ % $ %
$ $
2.
Refer to the income statements in (1) above. For both present operations and the proposed new operations, Compute:
a. The degree of operating leverage.
Present Proposed
Degree of operating leverage
b. The break-even point in dollars. (Omit the "$" sign in your response.)
Present Proposed
Break-even point in dollars $ $
c.
The margin of safety in both dollar and percentage terms. (Omit the "$" and "%" signs in your response.)
Present Proposed
Margin of safety in dollars $ $
Margin of safety in percentage % %
3.
Refer again to the data in (1) above. As a manager, what factor would be paramount in your mind in deciding whether to purchase the new equipment? (Assume that ample funds are available to make the purchase.)
Reserves and surplus of the company
Performance of peers in the industry
Cyclical movements in the economy
Stock level maintained
4.
Refer to the original data. Rather than purchase new equipment, the marketing manager argues that the company’s marketing strategy should be changed. Instead of paying sales commissions, which are included in variable expenses, the marketing manager suggests that salespersons be paid fixed salaries and that the company invest heavily in advertising. The marketing manager claims that this new approach would increase unit sales by 50% without any change in selling price; the company’s new monthly fixed expenses would be $289,800; and its net operating income would increase by 25%. Compute the break-even point in dollar sales for the company under the new marketing strategy. (Omit the "$" sign in your response.)
New break even point in dollar sales $
1.
Present
Sales $966,000 $21.00 100.0% $966,000 $21.00 100.0%
Variable expenses $676,200 $14.70 69.9% $616,320 $13.40 63.8%
Contribution margin $289,800 $6.30 30.0% $349,680 $7.60 36.2%
Fixed expenses $231,840 23.9% $521,640 53.9%
Net operating income $57,960 6.0% -$171,960 -17.8%
Proposed
Sales $966,000 $21.00 100.0% $966,000 $21.00 100.0%
Variable expenses $676,200 $14.70 69.9% $616,320 $13.40 63.8%
Contribution margin $289,800 $6.30 30.0% $349,680 $7.60 36.2%
Fixed expenses $231,840 23.9% $521,640 53.9%
Net operating income $57,960 6.0% -$171,960 -17.8%
2.
a.
Present: Degree of operating leverage = Contribution margin / Net operating income = $289,800 / $57,960 = 5
Proposed: Degree of operating leverage = Contribution margin / Net operating income = $349,680 / -$171,960 = -2.03
b.
Present: Break-even point in dollars = Fixed expenses / Contribution margin per unit = $231,840 / $6.30 = $36,800
Proposed: Break-even point in dollars = Fixed expenses / Contribution margin per unit = $521,640 / $7.60 = $68,580
c.
Present: Margin of safety in dollars = Actual sales - Break-even point in dollars = $966,000 - $36,800 = $929,200
Margin of safety in percentage = Margin of safety in dollars / Actual sales * 100 = $929,200 / $966,000 * 100 = 96.19%
Proposed: Margin of safety in dollars = Actual sales - Break-even point in dollars = $966,000 - $68,580 = $897,420
Margin of safety in percentage = Margin of safety in dollars / Actual sales * 100 = $897,420 / $966,000 * 100 = 92.95%
3.
As a manager, the paramount factor in deciding whether to purchase the new equipment would be the cyclical movements in the economy. The industry in which the company operates is sensitive to economic conditions, so it is crucial to consider the potential impact of the equipment purchase on profitability during different economic cycles.
4.
To compute the break-even point in dollar sales for the company under the new marketing strategy, we need to calculate the new fixed expenses.
New fixed expenses = Current fixed expenses - Variable expenses saved from sales commissions + Additional fixed expenses for salaries
New fixed expenses = $231,840 - ($676,200 * 50%) + $289,800 = $48,540
Break-even point in dollar sales = New fixed expenses / Contribution margin ratio = $48,540 / 30% = $161,800
1. Contribution Format Income Statements:
Present Operations:
Amount Per Unit %
Sales $ 966,000 $ 21.00 100.00%
Variable expenses
Contribution margin
Fixed expenses
Net operating income
Proposed Operations (with new equipment):
Amount Per Unit %
Sales $ $ 100.00%
Variable expenses
Contribution margin
Fixed expenses
Net operating income
2. a. Degree of Operating Leverage:
Present Operations:
Degree of operating leverage
Proposed Operations:
Degree of operating leverage
b. Break-even Point in Dollars:
Present Operations:
Break-even point in dollars $
Proposed Operations:
Break-even point in dollars $
c. Margin of Safety:
Present Operations:
Margin of safety in dollars $
Margin of safety in percentage %
Proposed Operations:
Margin of safety in dollars $
Margin of safety in percentage %
3. The factor that would be paramount in deciding whether to purchase the new equipment would be "Cyclical movements in the economy."
4. Break-even Point in Dollar Sales:
New break-even point in dollar sales $
1. To prepare two contribution format income statements, one showing present operations and one showing the proposed new operations with the new equipment, we need to calculate the per unit amounts for sales, variable expenses, and fixed expenses for both scenarios.
Present Operations:
- Sales: $966,000 / 46,000 units = $21 per unit
- Variable expenses: $676,200 / 46,000 units = $14.70 per unit
Proposed New Operations:
- Sales: $966,000 / 46,000 units = $21 per unit
- Variable expenses: ($676,200 - ($6.30 * 46,000)) / 46,000 units = $8.70 per unit
- Fixed expenses: $521,640
Now we can prepare the two income statements:
Present Proposed
Amount Per Unit % Amount Per Unit %
Sales $ 966,000 $ 21.00 100% $ 966,000 $ 21.00 100%
Variable Expenses $ 676,200 $ 14.70 70% $ 400,200 $ 8.70 41%
Contribution Margin $ 289,800 $ 6.30 30% $ 565,800 $ 12.30 59%
Fixed Expenses $ 231,840 $ 521,640
Net Operating Income $ 57,960 $ 44,160
2a. The degree of operating leverage measures the relationship between the contribution margin and the net operating income. It is calculated as follows:
Degree of Operating Leverage = Contribution Margin / Net Operating Income
For present operations:
Degree of Operating Leverage = $289,800 / $57,960 = 5
For proposed new operations:
Degree of Operating Leverage = $565,800 / $44,160 = 12.8
2b. The break-even point in dollars is the level of sales at which the company's net operating income is zero. It is calculated as follows:
Break-even Point in Dollars = Fixed Expenses / Contribution Margin Ratio
For present operations:
Contribution Margin Ratio = Contribution Margin / Sales = $289,800 / $966,000 = 0.3
Break-even Point in Dollars = $231,840 / 0.3 = $772,800
For proposed new operations:
Contribution Margin Ratio = Contribution Margin / Sales = $565,800 / $966,000 = 0.585
Break-even Point in Dollars = $521,640 / 0.585 = $892,308
2c. The margin of safety is the amount by which the company's actual sales exceed the break-even point. It can be calculated in both dollar and percentage terms.
For present operations:
Margin of Safety in Dollars = Actual Sales - Break-even Point = $966,000 - $772,800 = $193,200
Margin of Safety Percentage = Margin of Safety in Dollars / Actual Sales = $193,200 / $966,000 = 20%
For proposed new operations:
Margin of Safety in Dollars = Actual Sales - Break-even Point = $966,000 - $892,308 = $73,692
Margin of Safety Percentage = Margin of Safety in Dollars / Actual Sales = $73,692 / $966,000 = 7.63%
3. As a manager, the factor that would be paramount in deciding whether to purchase the new equipment would be the cyclical movements in the economy. Since the industry is sensitive to economic conditions and profits vary considerably from year to year, it is important to consider the potential impact of economic cycles on the company's operations and profitability.
4. To calculate the break-even point in dollar sales under the new marketing strategy, we can use the following formula:
Break-even Point in Dollar Sales = (Fixed Expenses + Desired Increase in Net Operating Income) / Contribution Margin Ratio
For the new marketing strategy:
Fixed Expenses = $289,800
Desired Increase in Net Operating Income = $57,960 * 1.25 = $72,450
Contribution Margin Ratio = $289,800 / $966,000 = 0.3
Break-even Point in Dollar Sales = ($289,800 + $72,450) / 0.3 = $1,205,500