A. Compute The Degree of Operating Leverage at The Current Level of Sales

Feather Friends, Inc. distributes a high-quality wooden birdhouse that sells for $20 per unit.
Variable costs are $8 per unit, and fixed costs total $180,000 per year.
Answer the following independent questions:

1. What is the product’s CM ratio?
Contribution margin ratio = Contribution margin/sales

Contribution margin = selling price – variable cost = 20-8 = 12
Contribution margin ratio = 12/20 = 60%
2. Use the CM ratio to determine the break-even point in sales dollars.
Breakeven sales dollars = Fixed cost/contribution margin ratio

= 180,000/60% = $300,000
3. Due to an increase in demand, the company estimates that sales will increase by $75,000
during the next year. By how much should net operating income increase (or net loss decrease)
assuming that fixed costs do not change?
The net income would increase by the contribution margin since there is no change in the fixed
cost.
Increase in contribution margin = Increase in sales X contribution margin ratio
= 75,000 X 60% = $45,000
Net operating income will increase by $45,000
4. Assume that the operating results for last year were:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $400,000
Variable expenses . . . . . . . . . . . . . . . . . . . 160,000
Contribution margin . . . . . . . . . . . . . . . . . . 240,000
Fixed expenses . . . . . . . . . . . . . . . . . . . . . 180,000
Net operating income . . . . . . . . . . . . . . . . $ 60,000
a. Compute the degree of operating leverage at the current level of sales.
Degree of operating leverage = (Sales – variable cost)/(Sales – variable cost – fixed cost)
=(400,000-160,000)/(400,000-160,000-180,000)
= 4 times
b. The president expects sales to increase by 20% next year. By what percentage should net
operating income increase?
The degree of operating leverage is the sensitivity of change in operating income for a given
change in sales. If the sales increase by 20%, operating income will increase by 20% X 4 = 80%
5. Refer to the original data. Assume that the company sold 18,000 units last year. The sales
manager is convinced that a 10% reduction in the selling price, combined with a $30,000
increase in advertising, would cause annual sales in units to increase by one-third. Prepare two
contribution format income statements, one showing the results of last year’s operations and
one showing the results of operations if these changes are made. Would you recommend that
the company do as the sales manager suggests?
The income statements are

Proposed:24,000 units
Last Year:18,000 units (increase by 1/3)
Amount Per Unit Amount Per Unit
Sales 360,000 20 432,000 18
Less variable expenses 144,000 8 192,000 8
Contribution margin 216,000 12 240,000 10
Less fixed expenses 180,000 210,000
Net operating income 36,000 30,000
Increase in sales = one –third = 18,000 X 1.3 = 6,000 and so new sales = 24,000
Price is less by 10% = 20 X .9 = $18
Fixed cost increase by 30,000
Since the operating income is lower, we would not accept the recommendation.
6. Refer to the original data. Assume again that the company sold 18,000 units last year. The
president does not want to change the selling price. Instead, he wants to increase the sales
commission by $1 per unit. He thinks that this move, combined with some increase in
advertising, would increase annual sales by 25%. By how much could advertising be increased
with profits remaining unchanged? Do not prepare an income statement; use the incremental
analysis approach.
Current contribution margin = (20-8) X 18,000 units = 216,000

With the change, the new contribution margin will be $11 since the commission will increase by
$1 and the units will be 18,000 X 1.25 = 22,500
New contribution margin = 22,500 X 11 = 247,500
If the operating income is to be the same, then the increase in contribution margin can be used
for advertising expense. Then the contribution margin would be the same as now and with the
same fixed cost, the profit will be the same
Amount that can be spent on advertising = 247,500-216,000 = $31,500

A. Compute The Degree of Operating Leverage at The Current Level of Sales

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Feather Friends, Inc. distributes a high-quality wooden birdhouse that sells for $20 per unit.

Answer the following independent questions:

Contribution margin ratio = Contribution margin/sales

2. Use the CM ratio to determine the break-even point in sales dollars.

Breakeven sales dollars = Fixed cost/contribution margin ratio

4. Assume that the operating results for last year were:

a. Compute the degree of operating leverage at the current level of sales.

The income statements are

Sales 360,000 20 432,000 18

Less variable expenses 144,000 8 192,000 8

Contribution margin 216,000 12 240,000 10

Less fixed expenses 180,000 210,000

Net operating income 36,000 30,000

Current contribution margin = (20-8) X 18,000 units = 216,000

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