Question

Saruman Division produces memory enhancement kits for Barad – Dur’s UrukHai Microwaves. Sales of the kits have been very erratic, with some months showing a profit and some months showing a loss. Currently, the division produces as many units as are required for sales. The division’s contribution margin income statement for the most recent month is given below:

Sales (13,500 units at $20 per unit) $270,000

Variable expenses (all production related) 189,000

Contribution margin 81,000

Fixed expenses (all production related) 90,000

Net operating loss $ (9,000)

1. Compute the division’s CM ratio and its break-even point in units.

2. Refer to the original data. By automating, the division could slash its unit variable cost in half. However, fixed costs would increase by $118,000 per month.

(i) At what volume level would the division be indifferent between automation and the current non-automated process? That is, what is the decision rule for automation in terms of volume?

(ii) Based on the decision rule above, would you recommend that the division automate its operations if volume continues at the current level?

(iii) Assume for this part that the selling price per kit is $24 per unit. All other data are the same as stated in the problem. What is the Operating Leverage Ratio (OLR)? If sales decline by 10%, what does the OLR predict will be the effect on operating income?

(iv) Assume just for this part only that production of memory kits is increased to 15,000 units. However, sales are still 13,500 units. All other data are the same as stated in the problem. What would be the division’s reported income under Absorption Costing?

Answer 1

Answer is given below