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		$1,620,000		$1,620,000
Variable costs		1,296,000		648,000
Contribution margin		324,000		972,000
Fixed costs		84,000		732,000
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

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

		Increase in Net Income
Manual System		$
Computerized System		$

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

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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

DETAILS GIVEN IN QUESTION:

CVP STATEMENT OF Casas Modernas of Juarez, Mexico, IS GIVEN.

IT IS PLANNING TO DO A MAJOR CHANGE IN ITS COST STRUCTURE AND replacing the draftsmen with a computerized drafting system.

ANSWER:

1	DEGREE OF OPERATING LEVERAGE = CONTRIBUTION / NET INCOME
		MANUAL SYSTEM	COMPUTERIZED SYSTEM
	CONTRIBUTION (A)	324,000	972,000
	NET INCOME (B)	240,000	240,000
	OPERATING LEVERAGE (A / B)	1.35	4.05
2	INCREASE IN NET INCOME IF SALES INCREASED BY $ 110,000
	CONTRIBUTION (A)	324,000	972,000
	SALES (B)	1,620,000	1,620,000
	CONTRIBUTION RATIO (A/B ) X 100	20%	60%
		MANUAL SYSTEM	COMPUTERIZED SYSTEM
	ORIGINAL SALES	1,620,000	1,620,000
	(+) INCREASE	110,000	110,000
	NEW SALES	1,730,000	1,730,000
	(X) CONTRIBUTION RATIO	20%	60%
	NEW CONTRIBUTION	346,000	1,038,000
	(-) FIXED COST	84,000	732,000
	NEW NET INCOME	262,000	306,000
	(-) OLD NET INCOME	240,000	240,000
	INCREASE IN NET INCOME	22,000	66,000
3	WHICH ALTERNATIVE WILL PRODUCE HIGHER NET INCOME?
	COMPUTERIZED SYSTEM WILL PRODUCE HIGHER NET INCOME
4	MARGIN OF SAFETY RATIO
		MANUAL SYSTEM	COMPUTERIZED SYSTEM
	NET INCOME (A)	240,000	240,000
	CONTRIBUTION RATIO (B)	20%	60%
	MARGIN OF SAFETY (C = A / B)	1,200,000	400,000
	SALES (D)	1,620,000	1,620,000
	MARGIN OF SAFETY RATIO (C / D)	0.74	0.25
5	WHICH ALTERNATIVE WOULD SUSTAIN GREATER DECLINE IN SALES BEFORE OPERATING AT LOSS
	MANUAL SYSTEM WILL SUSTAIN GREATER DECLINE IN SALES AS ITS MARGIN OF SAFETY RATIO IS
	HIGHER.