Question

Shelly's Boutiques and Crafts had revenue of $5,700,000 this year on sales of 575,000 units. Variable costs were 35% and fixed costs totaled $3,150,000. Although the first five years were relatively profitable, increases in competition have led to a negative trend in profitability that has led them to the point where they have to make some changes to stay afloat. The company is evaluating two options to stay afloat.

Option 1:Purchase machinery to automate their operations. This machinery costs $625,000, but will decrease variable costs by 9%.

Option 2:Outsource the production of one of their main components that requires a substantial amount of machinery and skilled labor. This will reduce fixed costs by $425,000, but increases variable costs from their current 35% of sales to 40% of sales.

c.) Calculate the operating leverage before applying any of the options: What is the contribution margin in Total? What is the operating income in total? What is the operating leverage factor?

Answer 1

Operating leverage before applying any of the options:

Particulars	Amount in $
Revenue	57,00,000
Less: Variable cost (35% of revenue)	19,95,000
Contribution margin	37,05,000
Less: Fixed cost	31,50,000
Net profit	5,55,000

Evaluating Options:

Particulars	Before applying options	Option 1 (purchase machinery	Option 2 (outsource production)
Revenue	57,00,000	57,00,000	57,00,000
Less: Variable cost	19,95,000 (35% of revenue)	14,82,000[(35-9)% of revenue)]	22,80,000 (40% of revenue)
Contribution margin /operating income	37,05,000	42,18,000	34,20,000
Less: Fixed cost	31,50,000	37,75,000	27,25,000
Net profit	5,55,000	4,43,000	6,95,000

Assuming same level of revenue as current and write off of machinery cost against profit option 2 shows net profit higher than option 1 by $2,52,000. However, contribution margin is higher in option 1 as compared to option 2 by $ 7,98,000 if fixed cost is proportionately over years.