Zzip Company manufactures skateboards which currently sell f

Zzip Company manufactures skateboards, which currently sell for $38.00. The skateboards are manufactured in an antiquated plant that relies heavily on direct labour workers. Thus, variable costs. are high, totalling $22.80 per skateboard, of which 60% is direct labour cost. Over the past year, the company sold 40,000 skateboards, with the following operating results: Sales (40,000 skateboards) $1,520,000 Variable expenses 912,000 Contribution margin 608,000 Fixed expenses 480,000 Net operating income $ 128,000 Management is anxious to maintain and perhaps even improve its present level of income from the skateboards. Required: A) Compute the break-even point in skateboards, and the degree of operating leverage at last year\'s level of sales. B) The company is worried that labour rates may increase in future years, increasing manufacturing costs. The company does not believe that it will be able to increase its selling prices to maintain current net income levels, due to the competitiveness of the skateboard market. Consequently, the company is considering the construction of a brand new, automated plant. Using the same sales level of $1,520,000, the new plant would slash variable costs by 40%, but it would cause fixed costs to increase by 90%. If the new plant is built, what would be the company\'s new break-even point in skateboards? C) If the new plant is built, how many skateboards will have to be sold next year to earn the same net operating income as last year of $128,000? What would be the new degree of operating leverage? D) If you were a member of top management, would you be in favour of constructing the new plant? Clearly but concisely explain. Base your answer on the calculations you conducted above, as well as on qualitative factors.

Solution

Solution

Zzip Company

Break-even point in skateboards = fixed cost/contribution margin per skateboard

Contribution margin per skateboard = selling price – variable cost

Selling price per skateboard = $38

Variable cost per skateboard = $22.80

Contribution margin per skateboard = $15.20

Fixed expenses = $480,000

Break-even point in skateboards = $480,000/$15.20 = 31,578 skateboards

Degree of operating leverage = contribution margin/net income

Contribution margin = $608,000

Net income = $128,000

Degree of operating leverage = $608,000/$128,000 = 4.75

B. Determination of the company’s new break-even point in skateboards assuming new plant is built:

When new plant is built,

Variable costs decrease by 40%, hence new variable cost = $22.80 – 40% of $22.80

New variable cost per skateboard = $13.68

New contribution margin = $38 - $13.68 = $24.32

New Fixed expenses = $480,000 + 90% of $480,000 = $912,000

New break-even point in skateboards = $912,000/$24.32 = 37,500 skateboards

Hence, break-even point in skateboards = 37,500

C. Determination of the number of skateboards to be sold to earn the same net income:

Desired number of units to be sold

= (fixed expenses + target profit)/new contribution margin per skateboard

Fixed expenses = $912,000

Target profit = $128,000

New contribution margin per skateboard = $24.32

Desired number of units = (912,000 + 128,000)/24.32

                                    = $1,040,000/$24.32

                                    = 42,763 skateboards

Hence, the company has to sell 42,763 skateboards to earn the same level of net income.

New degree operating leverage = new contribution margin/net income

New contribution margin = $24.32 x 42,763 = $1,039,996

Net income = $128,000

Degree of operating leverage = $1,039,996/$128,000 = 8.12

Calculation of new degree of operating leverage at normal sales level:

New contribution margin = $24.32 x 40,000 skateboards = $972,800

Net income = 128,000

Degree of operating leverage = $972,800/128,000 = 7.6

D.

As a member of the top management, we would favor the construction of new plant.

An increase in degree of automation indicates that a high change in net income with changes in sales units.

Hence, the net income would increase by 2.85 more times with change in sales when the company is automated.

            Also, construction of the new plant would reduce variable cost per skateboard by 40%. However, the break-even point in skateboards increases by 5,922 (37,500 – 31,578), which indicates that the company needs to sell an additional 5,922 skateboards to break-even when automation is adopted.

Qualitative factors: