MicroImage Technology, Inc. produces miniature digital  color cameras that can be attached to endoscopes and other medical devices. The cameras sell for $215 per unit and are disposed of after each use. For 2014, the company’s first full year of operation, the company had sales of 80,000 units and a net loss of $9,810,000, as follows:

MicroImage Technology, Inc.
Income Statement
for the Year ended December 31, 2014
Sales Revenue?$17,200,000
Less: cost of goods sold? 18,360,000
Gross Profit (loss)? (1,160,000)
Less: Selling and administrative expenses:
Selling expense?$3,750,000
Administrative expense? 4,900,000? 8,650,000
Net loss?($9,810,000)

The company is closely held, with six major inventors. Early in the first quarter of 2015, Warren Logan, company CFO, was preparing to meet with them to present profitability estimates for the coming two years. He expected the meeting to be somewhat hostile. Two days before, he had received an email from one of the investors, Sanjay Patel:

I expected a net loss but not this big. And I certainly didn’t expect a negative gross profit! It looks like the more we sell, the more we’ll lose. I hope you come to the investor meeting next week with some explanations and some better numbers.

In preparing for the meeting, Warren assembled the following information based on results for 2014:
Units sold?80,000
Units produced?80,000
Selling price? $215
Manufacturing costs:
Direct materials costs? $1,280,000
Direct labor costs? 1,200,000
Total direct manufacturing costs? $2,480,000
Variable manufacturing overhead:
Equipment maintenance? 160,000
Inspection costs? ? 400,000
Miscellaneous variable manufacturing overhead 320,000
Total variable manufacturing overhead? 880,000
Fixed manufacturing overhead:
Rent? 1,800,000
Depreciation? 5,000,000
Supervisory salaries ? 4,500,000
Miscellaneous fixed manufacturing overhead? 3,700,000
Total fixed manufacturing costs? 15,000,000
Total manufacturing costs? $18,360,000
Operating Expenses:
Selling expenses
Variable selling expense:
Shipping?$ 280,000
Commissions? 800,000
Travel? 120,000
Total variable selling expenses ?$1,200,000
Fixed selling expense:? ?
Miscellaneous fixed selling expense 650,000
Total fixed selling expenses? 2,550,000
Total selling expenses?$ 3,750,000
Administrative expenses (all fixed)
Research and development? $ 2,700,000
Administrative salaries? ? 1,300,000
Miscellaneous administrative expense 900,000? .
Total administrative expenses? 4,900,000
Total operating expenses? $8,650,000?

Assumptions for 2015
1. The company will hire two additional sales managers at a base salary of $90,000 each.
2. R&D will be cut by $1,100,000.
3. Unit sales will increase by 30 percent.

Assumptions for 2016
1. The company will hire one additional sales manager at a base salary of $90,000.
2. R&D will be increased by $600,172 over 2015.
3. Unit sales will increase by 60 percent over 2015.


i: Recast the absorption costing income statement for 2014 into a variable costing format. Does it appear, as Sanjay Patel contends, that the more the company sells, the more it loses? Explain.

ii. Warren Logan, CFO, has developed assumptions that he believes are reasonable for 2015 and 2016. Using these assumptions, prepare budgeted income statements for 2015 and 2016 using the variable costing method. Are the major investors likely to find forecasted profits encouraging? Explain.

iii. Calculate the following for 2016:
a. Unit contribution margin.
b. Sales in dollars and units needed to breakeven.
c. Margin of safety in units and dollars.
d. Degree of operating leverage.
Briefly explain and interpret the company’s margin of safety and its degree of operating leverage.