Solutions to Formative Assignments on Chapter 6

EXERCISE 6-14

(a)
Contribution Net Degree of
Margin ÷ Income = Operating
Leverage
Armstrong $260,000 ÷ $100,000 = 2.60
Contador $450,000 ÷ $100,000 = 4.50

Interpretation: Contador has a higher degree of operating

leverage. Its earnings would increase (decrease) by a greater
amount than Armstrong if each experienced an equal increase
(decrease) in sales.

(b)
Armstrong Contador
Company Company
Sales $550,000** $550,000***
Variable costs 264,000** 55,000***
Contribution 286,000** 495,000***
margin 160,000** 350,000***
Fixed costs $126,000** $145,000***
Net income

*$500,000 X 1.1
**$240,000 X 1.1
***$ 50,000 X 1.1

(c) Each company experienced a $50,000 increase in sales.

However, because of Contador’s higher operating leverage,
it experienced a $45,000 ($145,000 – $100,000) increase in
net income while Armstrong experienced only a $26,000
($126,000 – $100,000) increase. This is what we would
have expected, since Contador’s degree of operating
leverage exceeds that of Armstrong.
EXERCISE 6-15

(a)
Contribution Degree of
÷ Net Income = Operating Leverage
Margin
Manual system $300,000 ÷ $200,000 = 1.50
Computerized
system $900,000 ÷ $200,000 = 4.50

(b) The computerized system would produce profits that are

3.0 times
(4.50 ÷ 1.50) as much as the manual system. With a
$150,000 increase in sales, net income would increase
$30,000 ($230,000 – $200,000)
under the manual system and $90,000 ($290,000 –
$200,000) under the computerized system.

Manual Computerized
System System
Sales $1,650,000 $1,650,000
Variable costs 1,320,000* 660,000**
Contribution 330,000 990,000
margin 100,000 700,000
Fixed costs $ 230,000 $ 290,000
Net income

*($1,200,000 ÷ $1,500,000) X $1,650,000

**($600,000 ÷ $1,500,000) X $1,650,000

(c)
(Actual Sales – Break-even ÷ Actual = Margin of Safety
Sales) Sales Ratio
Manual system ($1,500,000 – $500,000*) ÷ $1,500,000 = .67
Computerized
system ($1,500,000 – $1,166,667**) ÷ $1,500,000 = .22

*$100,000 ÷ ($300,000 ÷ $1,500,000)

**$700,000 ÷ ($900,000 ÷ $1,500,000)

The manual system could weather the greater decline in

sales before reaching the break-even point. Under the
manual system sales could drop 67% before suffering a
loss, while sales under the computerized system could
only decline by 22% before suffering a loss.
Discussion Question:
Indicate how operating leverage affects profitability.

Operating leverage refers to the degree to which a company’s

net income reacts to a change in sales. Operating leverage is
determined by a company’s relative use of fixed versus
variable costs. Companies with high fixed costs relative to
variable costs have high operating leverage. A company with
high operating leverage experiences a sharp increase
(decrease) in net income with a given increase (decrease) in
sales. The degree of operating leverage is measured by
dividing contribution margin by net income.

EXERCISE 6-10

(a) Sales mix percentage

iPad division: $600,000 ÷ ($600,000 + $400,000) = .60
iPod division: $400,000 ÷ ($600,000 + $400,000) = .40

Contribution margin ratio:

iPad division: $180,000 ÷ $600,000 = .30
iPod division: $140,000 ÷ $400,000 = .35

(b) Weighted-average contribution = $320,000 = .32   OR

margin ratio $1,000,000

Weighted-average contribution
margin ratio = (.60 X .30) + (.40 X .35) = .32

(c) Break-even point in dollars = $120,000 ÷ .32 = $375,000

(d) Sales dollars needed at break-even point for each

division
iPad division: $375,000 X .60 = $225,000
iPod division: $375,000 X .40 = $150,000

EXERCISE 6-9

(a) Weighted-average unit

contribution margin = ($40 X .35) + ($20 X .55) + ($60
X .10) = $31

Break-even point in units = $620,000 ÷ $31 = 20,000

(b) Shoes (20,000 X .35) = 7,000 pairs of shoes

Gloves (20,000 X .55) = 11,000 pairs of gloves
Range-finders (20,000 X .10) = 2,000 range-finders
(c) Shoes: 7,000 X $40 = $280,000
Gloves: 11,000 X $20 = 220,000
Range-finders: 2,000 X $60 = 120,000
Total contribution margin 620,000
Fixed costs 620,000
Net income $ 0

Discussion Question:
Explain the term sales mix and its effects on break- even
sales.

Sales mix is the relative proportion in which each product is

sold when a company sells more than one product. For a
company with a small number of products, break-even sales
in units is determined by using the weighted-average unit
contribution margin of all the products. If the company sells
many different products, then calculating the break-even
point using unit information is not practical. Instead, in a
company with many products, break-even sales in dollars is
calculated using the weighted-average contribution margin
ratio.