Question

Feather Friends, Inc., distributes a high-quality wooden birdhouse that sells for $80 per unit. Variable expenses are $40.00 per unit, and fixed expenses total $180,000 per year. Its operating results for last year were as follows:
Sales $1,920,000
Variable expenses 960,000
Contribution margin 960,000
Fixed expenses 180,000
Net operating income $780,000

Required:
a. Assume the president expects this year's sales to increase by 19%. Using the degree of operating leverage from last year, what percentage increase in net operating income will the company realize this year?
b. If the sales manager is right, what would be this year's net operating income if his ideas are implemented?

Answer 1

Answer:

a. Degree of operating leverage is 1.23; and Percentage increase in net income is 23.37%.

b. Therefore, this year's net operating income would be $636,000 if the sales manager's ideas are implemented.

Explanation:

a. Assume the president expects this year's sales to increase by 19%. Using the degree of operating leverage from last year, what percentage increase in net operating income will the company realize this year?

The degree of operating leverage (DOL) refers to a metric used to gauge the amount by which the operating income of a firm will change as a result of a change in its sales. DOL can be calculated as follows:

Degree of operating leverage = contribution margin / net income = 960,000 / 780,000 = 1.23

From the DOL, the percentage increase in net income can can be determined as follows:

Percentage increase in net income = Degree of operating leverage * Expected percentage increase in net income = 1.23 * 19% = 23.37%

b. If the sales manager is right, what would be this year's net operating income if his ideas are implemented?

Note: This required part b is not complete. The complete requirement is therefore presented as follows:

The sales manager is convinced that a 13% reduction in the selling price, combined with a $72,000 increase in advertising, would increase this year's unit sales by 25%. If the sales manager is right, what would be this year's net operating income if his ideas are implemented?

The answer to par b is now provided as follows:

Initial sales in unit = Initial sales / Initial selling price = $1,920,000 / $80 = 24,000 units

This year's sales in unit = Initial sales in unit * (100% + percentage increase in sales) = 24,000 * 125% = 30,000 units

This year's sales = This year's sales in unit * [Old selling price * (100% - expected percentage fall in selling price)] = 30,000 * [$80 * (100% - 13%)] = $2,088,000    

This year's operating income can now be determined as follows:

                             Feather Friends, Inc.

           Income Statement (Variable Costing)

                                  For this year

Particulars                                                     Amount ($)    

Sales                                                              2,088,000                    

Variable expense (30,000 * $40)               (1,200,000)    

Contribution margin                                        888,000

Fixed expense (180,000 + 72,000)               (252,000)  

Net operating income                                   636,000  

Therefore, this year's net operating income would be $636,000 if the sales manager's ideas are implemented.