Question

Casas Modernas of Juarez, Mexico, is contemplating a major change in its cost structure. Currently, all of its drafting work is performed by skilled draftsmen. Rafael Jiminez, Casas’ owner, is considering replacing the draftsmen with a computerized drafting system. However, before making the change, Rafael would like to know the consequences of the change, since the volume of business varies significantly from year to year. Shown below are CVP income statements for each alternative.

		Manual System		Computerized System
Sales		$1,740,000		$1,740,000
Variable costs		1,392,000		696,000
Contribution margin		348,000		1,044,000
Fixed costs		108,000		804,000
Net income		$240,000		$240,000

(a)

Correct answer iconYour answer is correct.

Determine the degree of operating leverage for each alternative. (Round answers to 2 decimal places, e.g. 1.25.)

		Degree of Operating Leverage
Manual System
Computerized System

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Solution

  

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(b)

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Calculate the increase in Net income for each alternative if sales increased by $142,000.

		Increase in Net Income
Manual System		$
Computerized System		$

Which alternative would produce the higher net income ?                                                                       Computerized SystemManual System

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(c)

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Calculate the margin of safety ratio. (Round ratios to 2 decimal places, e.g. 0.25.)

		Margin of Safety ratio
Manual System
Computerized System

Using the margin of safety ratio, determine which alternative could sustain the greater decline in sales before operating at a loss.                                                                       Computerized SystemManual System

Answer 1

a
	Degree of Operating Leverage
Manual System	1.45
Computerized System	4.35
b
	Increase in Net Income
Manual System	28400
Computerized System	85200
Computerized System produce the higher operating income
c
	Margin of Safety ratio
Manual System	0.69
Computerized System	0.23
Manual System could sustain the greater decline in sales

Workings:
	Manual System	Computerized System
Contribution margin	348000	1044000
Divide by sales	1740000	1740000
Contribution margin ratio	20%	60%
	Manual System	Computerized System
Contribution margin	348000	1044000
Divide by Operating income	240000	240000
Degree of Operating Leverage	1.45	4.35
	Manual System	Computerized System
Increase in sales	142000	142000
X Contribution margin ratio	20%	60%
Increase in Net Income	28400	85200
	Manual System	Computerized System
Fixed costs	108000	804000
/ Contribution margin ratio	20%	60%
Break even sales	540000	1340000
	Manual System	Computerized System
Sales	1740000	1740000
Less: Break even sales	540000	1340000
Margin of Safety sales	1200000	400000
	Manual System	Computerized System
Margin of Safety sales	1200000	400000
Divide by Sales	1740000	1740000
Margin of Safety ratio	0.69	0.23