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	$6.00
Direct labor per unit	$5.00	$12.00
Variable manufacturing overhead per unit	$4.00	$2.00
Fixed manufacturing overhead per year	$2,720,000.00	$860,000.00

Paper Mate's market research department has recommended an introductory unit sales price of $30. 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.
Answer

units

2. Labor-intensive manufacturing method.
Answer

units

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

units


2. Compute operating leverage for each alternative at a volume of 270,000 units. Round your answers two decimal places.

Capital-Intensive operating leverage Answer

Labor-Intensive operating leverage Answer

Answer 1

a.

	Capital Intensive	Labor Intensive
Direct materials per unit	$5.00	$6.00
Direct labor per unit	$5.00	$12.00
Variable manufacturing overhead per unit	$4.00	$2.00
Selling cost	$2	$2
Variable cost per unit (ii)	$16	$22
Selling price per unit (i)	$30	$30
Contribution margin per unit (i) - (ii)	$14	$8

1.

Capital-intensive manufacturing method.

Fixed costs = Fixed manufacturing overhead per year + Fixed selling costs

= 2,720,000 + 500,000

= $3,220,000

Break even point (units) = Fixed cost/Contribution margin per unit

= 3,220,000/14

= 230,000

2.

Labor-intensive manufacturing method.

Fixed costs = Fixed manufacturing overhead per year + Fixed selling costs

= 860,000 + 500,000

= $1,360,000

Break even point (units) = Fixed cost/Contribution margin per unit

= 1,360,000/8

= 170,000

b.

Let at Y units, total cost is same for both the methods.

Total cost of labor intensive method = Total cost of capital intensive method

22Y + 1,360,000 = 16Y + 3,220,000

6Y = $1,860,000

Y = 310,000

Hence, when 310,000 units are to be sold, total cost would be same under both the methods and Paper Mate would be indifferent between the two manufacturing methods.

2.

Contribution margin income statement

	Capital-intensive manufacturing method	Labor-intensive manufacturing method
Sales	270,000 x 30 = 8,100,000	270,000 x 30 = 8,100,000
Variable cost	270,000 x 16 = 4,320,000	270,000 x 22 = 5,940,000
Contribution margin	3,780,000	2,160,000
Fixed cost	3,220,000	1,360,000
Operating income	560,000	800,000

Degree of operating leverage = Contribution margin/Net operating income

Capital-Intensive operating leverage = 3,780,000/560,000

= 6.75

Labor-Intensive operating leverage = 2,160,000/800,000

= 2.7