Problem
The following information is taken from Bailey Limited's contribution format income statement for the most recent month:
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Sales (40,000 units)
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$800,000
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Variable expenses
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560,000
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Contribution Margin
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240,000
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Fixed Expenses
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192,000
|
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Net Operating Income
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$48,000
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Bailey Limited operates in an industry that is highly sensitive to economic cyclical movements. Profits vary greatly from year to year depending on general economic conditions. There is a lot of unused capacity at the company, and the company is looking for ways to improve profits.
Task
I. There is new equipment on the market that could allow Bailey Limited to automate a portion of its operations. It would reduce variable costs by $6 per unit. The fixed costs would however increase to a total of $432,000 each month. Using proper format, prepare two contribution format income statements, one reflecting current operations and one reflecting operations if the new equipment were purchased. In each statement, you should include a column for Amount, a column for Per Unit, and a column for Percentage. Please do not include percentages for fixed costs.
II. Refer to the income statements in (I) above. As part of both present operations and planned new operations, compute (i) the degree of operating leverage, (ii) the break-even point in dollars, and (iii) the margin of safety both in terms of dollar amounts and in terms of percentages.
III. Refer to (I) above once again. In your role as a manager, what factors are going to be the most important one in deciding whether or not to purchase the new equipment? You may assume that there are sufficient funds available to make this purchase.
IV. Refer to the original data. The marketing manager argues that the company should change its marketing strategy rather than purchase new equipment. As an alternative to paying commissions on sales, which are included in variable expenses, the marketing manager suggests to the company that salespeople be paid fixed salaries and more investments be made in advertisement.
According to the marketing manager, the new approach would increase unit sales by 50% without changing the price; the company's fixed expenses would increase by $240,000; and its net operating income would rise by 25%. Calculate the break-even point in dollar sales for the company based on the new marketing strategy. Would you agree with what the marketing manager proposed? Why or why not?