Problem
Morton Company's contribution format income statement for last month is given below:
Sales (43,000 units × $25 per unit) $ 1,075,000
Variable expenses 752,500
Contribution margin $ 322,500
Fixed expenses 258,000
Net operating income $ 64,500
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 $7.50 per unit. However, fixed expenses would increase to a total of $580,500 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) above. For both present operations and the proposed new operations, compute
a. The degree of operating leverage.
b. The break-even point in dollar sales.
c. The margin of safety in both dollar and percentage terms.
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 enough funds are available to make the purchase.)
Reserves and surplus of the company
Performance of peers in the indstry
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. 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 50% without any change in selling price; the company's new monthly fixed expenses would be $322,500, 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.