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

1. Determine the degree of operating leverage for each alternative.

2. Calculate the increase in Net income for each alternative if sales increased by $110,000? Which alternative would produce the higher net income?

3. Calculate the margin of safety ratio.Using the margin of safety ratio, determine which alternative could sustain the greater decline in sales before operating at a loss. (Computerized or Manual)

Answer 1

a
	Degree of Operating Leverage
Manual System	1.55
Computerized System	4.65
b
	Increase in Net income
Manual System	22000
Computerized System	66000
Computerized System produce the higher operating income
c
	Margin of Safety ratio
Manual System	0.65
Computerized System	0.22
Manual System could sustain the greater decline in sales

Workings:
	Manual System	Computerized System
Contribution margin	372000	1116000
Divide by sales	1860000	1860000
Contribution margin ratio	20%	60%
	Manual System	Computerized System
Contribution margin	372000	1116000
Divide by Operating income	240000	240000
Degree of Operating Leverage	1.55	4.65
	Manual System	Computerized System
Increase in sales	110000	110000
X Contribution margin ratio	20%	60%
Increase in Net Income	22000	66000
	Manual System	Computerized System
Fixed costs	132000	876000
/ Contribution margin ratio	20%	60%
Break even sales	660000	1460000
	Manual System	Computerized System
Sales	1860000	1860000
Less: Break even sales	660000	1460000
Margin of Safety sales	1200000	400000
	Manual System	Computerized System
Margin of Safety sales	1200000	400000
Divide by Sales	1860000	1860000
Margin of Safety ratio	0.65	0.22