Magic Realm, Inc., has developed a new fantasy board game. The company sold 15,000 games last year at a selling price of $20 per game. Fixed costs associated with the game total $182,000 per year, and variable costs are $6 per game. Production of the game is entrusted to a printing contractor. Variable costs consist mostly of payments to this contractor.
Required:
1. Prepare a contribution format income statement for the game last year and compute the degree of operating leverage.
2. Management is confident that the company can sell 18,000 games next year (an increase of 3,000 games, or 20%, over last year). Compute:
a. The expected percentage increase in net operating income for next year.
b. The expected total dollar net operating income for next year. (Do not prepare an income statement; use the degree of operating leverage to compute your answer.)

Explanation:

1. a. Contribution format income statement for the game last year and compute the degree of operating leverage

Magic Realm, Inc.

Contribution Income Statement

Total Per Unit

Sales                                $300,000            $20

Variable                            90,000                6

Contribution margin        210,000            $14

Fixed expense                 182,000

Net operating income      $28,000

1.b. Compute the degree of operating leverage

The degree of operating leverage is:

Degree of operating leverage = Contribution margin/Net operating income

                                                    = $210,000/$28,000

                                                   = 7.5

2. a. Sales of 18,000 games represent a 20% increase over last year's sales. Because the degree of operating leverage is 7.5, net operating income should increase by 7.5 times as much, or by 150% (7.5 × 20%).

                                                   = 150%

2.b. The expected total dollar amount of net operating income for next year would be:

Last year's net operating income         $28,000

Expected increase in net operating income

next year                                  (150% × $28,000) 42,000

Total expected net operating income       $70,000

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