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.

Calculate the increase in Net income for each alternative if sales increased by $127,000.

Which alternative would produce the higher net income ?

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.

		Manual System		Computerized System
Sales		$1,410,000		$1,410,000
Variable costs		1,128,000		564,000
Contribution margin		282,000		846,000
Fixed costs		100,065		664,065
Net income		$181,935		$181,935

Answer 1

Solution

Casas Modernas

Determination of increase in net income if sales for each alternative increased by $127,000:

Degree of operating leverage is an effective tool to determine the change in net income with change in sales level.

Degree of operating leverage = contribution margin/net income

	Manual System		Computerized System
degree of operating leverage
Contribution margin	$282,000		$846,000
Net Income	$181,935		$181,935
degree of operating leverage	282,000/181,935		846,000/181,935
	1.55		4.65
change in net income -
increase in sales	$127,000		$127,000
% increase in sales 127,000/1,410,000			127,000/1,410,000
	9%		9%
Change in net income = percent increase in sales x degree of operating leverage
	9% x 1.55		9% x 4.65
	13.96%		41.85%

Hence, when sales increase by $127,000, net income increases by 13.96% under manual system and 41.85% in computerized system.

Net income –

Manual System - $1,410,000 x 13.96% = $196,836

Computerized System = $1,410,000 x 41.85% = $590,085

Alternative 2, Computerized System would produce the higher net income.

Margin of safety ratio:

Margin of safety ratio = margin of safety/sales

Margin of safety = actual sales – Break-even sales

Actual sales = $1,410,000

Break-even sales = fixed cost/contribution margin ratio

Manual system –

Contribution margin ratio = contribution margin/sales

= (282,000/1,410,000) x 100 = 20%

Fixed cost = $100,065

Break-even sales = 100,065/20% = $500,325

Margin of safety = $1,410,000 - $500,325 = $909,675

Margin of safety = $909,675

Margin of safety ratio = (909,675/1,410,000) x 100 = 64.52%

Computerized System –

Contribution margin ratio = contribution margin/sales

= (846,000/1,410,000) x 100 = 60%

Fixed cost = $664,065

Break-even sales = 664,065/60% = $1,106,775

Margin of safety = 1,410,000 – 1,106,775 = $303,225

Margin of safety = $303,225

Margin of safety ratio = 303,225/1,410,000 = 21.51%

Hence, the margin of safety and margin of safety ratio for the two alternatives is as follows,

	Manual System	Computerized System
Margin of safety	$909,675	$303,225
margin of safety ratio	64.52%	21.51%

The margin of safety is highest for Manual System (64.52%) compared to the Computerized System (21.51%), hence Manual System - alternative could sustain the greater decline in sales before operating at a loss.