Question

Alternative Production Procedures and Operating Leverage
Assume Paper Mate is planning to introduce a new executive pen that can be manufactured using either a capital-intensive method or a labor-intensive method. The predicted manufacturing costs for each method are as follows:

	Capital Intensive	Labor Intensive
Direct materials per unit	$ 5.00	$ 8.00
Direct labor per unit	$ 5.00	$ 12.00
Variable manufacturing overhead per unit	$ 4.00	$ 2.00
Fixed manufacturing overhead per year	$ 2,440,000	$ 700,000

Paper Mate's market research department has recommended an introductory unit sales price of $40. The incremental selling costs are predicted to be $500,000 per year, plus $2 per unit sold.

(a) Determine the annual break-even point in units if Paper Mate uses the:
1. Capital-intensive manufacturing method.

2. Labor-intensive manufacturing method.

(b) Determine the annual unit volume at which Paper Mate is indifferent between the two manufacturing methods.

2. Compute operating leverage for each alternative at a volume of 250,000 units. Round your answers two decimal places.

Capital-Intensive operating leverage

Labor-Intensive operating leverage

Answer 1

Question A

Particulars	Capital Intensive	Labour Intensive
Fixed Cost	29,40,000	12,00,000
÷ Contribution Margin per Unit	24	16
Break Even Point in Units	122,500	75,000

Particulars	Capital Intensive	Labour Intensive
Sales Price per Unit	40	40
Less: Variable Costs per Unit	(16)	(24)
Contribution Margin per Unit	24	16

Particulars	Capital Intensive	Labour Intensive
Direct Materials Cost per Unit	5	8
Direct Labour Cost per Unit	5	12
Variable Manufacturing Overhead	4	2
Variable Selling and Administrative Expenses	2	2
Variable Cost per Unit	16	24

Particulars	Capital Intensive	Labour Intensive
Fixed Manufacturing Cost	24,40,000	700,000
Fixed Selling and Administrative Costs	500,000	500,000
Fixed Costs	29,40,000	12,00,000

Question 1B

Indifferent Point

As Sales Price is same under both methods so Sales Revenue will also be same.

Let Unit Sales = X

Sales Revenue for X Units = $ 40X

Variable Costs of Capital Intensive for X Units = $ 16X

Variable Costs of Labour Intensive for X Units = $ 24X

Fixed Costs of Labour Intensive Units = $ 12,00,000

Fixed Costs of Capital Intensive Units = $ 29,40,000

Sales Revenue for Capital Intensive - Variable Costs for Capital Intensive - Fixed Costs for Capital Intensive = Sales Revenue for Labour Intensive - Variable Costs for Labour Intensive - Fixed Costs for Labour Intensive

40X - 16X - 29,40,000 = 40X - 24X - 12,00,000

24X - 29,40,000 = 16X - 12,00,000

24X - 16X = 29,40,000 - 12,00,000

8X = 17,40,000

X = 17,40,000 / 8

X = 217,500 Units

At the Sales level of 217,500 Units Paper Mate will be indifferent towards both the alternative available.

Question 2

Particulars	Capital Intensive	Labour Intensive
Contribution Margin	6,000,000	4,000,000
÷ Operating Income	3,060,000	2,800,000
Operating Leverage	1.96 Times	1.43 Times

Particulars	Capital Intensive	Labour Intensive
Contribution Margin per Unit	24	16
* Units Sold	250,000	250,000
Contribution Margin	6,000,000	4,000,000

Particulars	Capital Intensive	Labour Intensive
Contribution Margin	6,000,000	4,000,000
Less: Fixed Costs	(2,940,000)	(1,200,000)
Operating Income	3,060,000	2,800,000