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		$1,860,000		$1,860,000
Variable costs		1,488,000		744,000
Contribution margin		372,000		1,116,000
Fixed costs		132,000		876,000
Net income		$240,000		$240,000

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

Calculate the increase in Net income for each alternative if sales increased by $110,000.

		Increase in Net Income
Manual System		$
Computerized System		$

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

1

Degree of Operating leverage = (Contribution / net income)
Manual system = ($372000 / $240000) = 1.55 (Ans)
Computerized system = ($1116000 / $240000) = 4.65 (Ans)

2

(Since fixed cost is already incurred, therefore any increase in contribution margin as a result of increase in sales will be result of increase in net income)
Manuam system = Contribution margin = ($372000 / $1860000) = 20%
So, Increase in net income = (20% X $110000) = $22000 (Ans)
Computerized system = Contribution margin = ($1116000 / $1860000) = 60%
So, Increase in Net income = (60% X $110000) = $66000 (Ans)

3

Margin of safety = (Net income / Contribution margin)
Manual system = ($240000 / 20%) = $1200000
So, Margin of safety ratio = (Margin of safety / total sales) = ($1200000 / $1860000) = 0.65 (Ans)
Computerized system = ($240000 / 60%) = $400000
So, Margin of safety ratio = (Margin of safety / Total sales) = ($400000 / $1860000) = 0.22 (Ans)

4

Manual system will suffer greater decline in sales before operating at a loss

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