Arcadia, Inc. manufactures souvenirs and sells the products to souvenir shops across Canada. Lisa McKay is the new owner, and is concerned about the low margins. She would like to fi nd a way to improve the company’s profitability. The accountant provides her the following financial information: sales are $250,000, of which 60% is cost of goods sold. Cost of goods sold consists of direct materials (20%), direct labour (30%), and fixed manufacturing overhead (50%). Operating expenses consist of variable expenses (40%) and fi xed expenses (60%). Arcadia pays a 40% tax rate and the net income is $15,000.

To reduce the company’s operating risks, McKay would like to review the company’s operations from another perspective. She would like to know how much the company needs to generate in order to break even. Based on the current cost structure, how sensitive is the profi t to a sale volume increase of 5%.
REQUIRED

A. Prepare an income statement in the gross margin format.
B. Prepare an income statement in the contribution margin format.
C. What is the break even in sales?
D. At the current sales level, what is the margin of safety and the degree of operating leverage?
E. Explain to Lisa the impact of a 5% sales increase. Looking at the current cost structure, what would you recommend to Lisa to improve the company’s financial performance?