Question

Alternative Production Procedures and Operating Leverage
Assume Sharpie, a brand of Sanford LP, is planning to introduce a new executive pen that can be manufactured using either a capital-intensive method or a labor-intensive method. The predicted manufacturing costs for each method are as follows:

	Capital Intensive	Labor Intensive
Direct materials per unit	$ 5.00	$ 6.00
Direct labor per unit	$ 5.00	$ 10.00
Variable manufacturing overhead per unit	$ 4.00	$ 2.00
Fixed manufacturing overhead per year	$ 2,440,000	$ 700,000

Sharpie's market research department has recommended an introductory unit sales price of $40. The incremental selling costs are predicted to be $500,000 per year, plus $2 per unit sold.

(a) Determine the annual break-even point in units if Sharpie uses the:
1. Capital-intensive manufacturing method.
Answer units

2. Labor-intensive manufacturing method.
Answer units

(b) Determine the annual unit volume at which Sharpie is indifferent between the two manufacturing methods.
Answer units

(c) Management wants to know more about the effect of each alternative on operating leverage.
1. Explain operating leverage and the relationship between operating leverage and the volatility of earnings.

They have little or no correlation because they are unrelated.

They are positively correlated, with increases in operating leverage accompanied by increases in the volatility of earnings.

They are negatively correlated, with increases in operating leverage accompanied by decreases in the volatility of earnings.

2. Compute operating leverage for each alternative at a volume of 250,000 units. Round your answers two decimal places.

Capital-Intensive operating leverage Answer
Labor-Intensive operating leverage Answer

3. Which alternative has the higher operating leverage? Why?

The labor intensive method has a higher operating leverage because of higher variable conversion costs.

The labor intensive method has a higher operating leverage because of lower variable manufacturing overhead.

The capital intensive method has a higher operating leverage because of the greater use of fixed assets.

The capital intensive method has a higher operating leverage because of the higher variable manufacturing overhead.

CVP Analysis and Special Decisions
Smoothie Citrus Company buys a variety of citrus fruit from growers and then processes the fruit into a product line of fresh fruit, juices, and fruit flavorings. The most recent year's sales revenue was $4,400,000. Variable costs were 60 percent of sales and fixed costs totaled $1,400,000. Smoothie is evaluating two alternatives designed to enhance profitability.

One staff member has proposed that Smoothie purchase more automated processing equipment. This strategy would increase fixed costs by $300,000 but decrease variable costs to 54 percent of sales.

Another staff member has suggested that Smoothie rely more on outsourcing for fruit processing. This would reduce fixed costs by $300,000 but increase variable costs to 65 percent of sales.

Round your answers to the nearest whole number.

(a) What is the current break-even point in sales dollars?
$Answer

(b) Assuming an income tax rate of 34 percent, what dollar sales volume is currently required to obtain an after-tax profit of $500,000?
$Answer

(c) In the absence of income taxes, at what sales volume will both alternatives (automation and outsourcing) provide the same profit?
$Answer

(d) Briefly describe one strength and one weakness of both the automation and the outsourcing alternatives.

Automation has less risk and a lower break-even point.

Outsourcing has higher profits if sales increase.

Automation has higher profits if sales increase. Outsourcing has less risk and a lower break-even point.

Automation has less risk. Outsourcing has higher profits if sales increase and a lower break-even point. Automation has higher profits if sales increase and a lower break-even point. Outsourcing has less risk.Not-for-Profit Applications

Determine the solutions to each of the following independent cases:

(a.) Collings College has annual fixed operating costs of $12,500,000 and variable operating costs of $1,000 per student. Tuition is $8,000 per student for the coming academic year, with a projected enrollment of 1,500 students. Expected revenues from endowments and federal and state grants total $250,000. Determine the amount the college must obtain from other sources.
$Answer

(b.) The Collings College Student Association is planning a fall concert. Expected costs (renting a hall, hiring a band, etc.) are $30,000. Assuming 3,000 people attend the concert, determine the break-even price per ticket. How much will the association lose if this price is charged and only 2,700 tickets are sold? (Do not use a negative sign with your answer.)
$Answer

(c.) City Hospital has a contract with the city to provide indigent health care on an outpatient basis for $25 per visit. The patient will pay $5 of this amount, with the city paying the balance ($20). Determine the amount the city will pay if the hospital has 10,000 patient visits.
$Answer

(d.) A civic organization is engaged in a fund-raising program. On Civic Sunday, it will sell newspapers at $1.25 each. The organization will pay $0.75 for each newspaper. Costs of the necessary permits, signs, and so forth are $500. Determine the amount the organization will raise if it sells 5,000 newspapers.
$Answer

(e.) Christmas for the Needy is a civic organization that provides Christmas presents to disadvantaged children. The annual costs of this activity are $5,000, plus $10 per present. Determine the number of presents the organization can provide with $20,000.
Answer presents

Answer 1

1.

(a)

1. Capital-intensive manufacturing method.
122,500 units

2. Labor-intensive manufacturing method.
60,000 units

	Capital Intensive	Labor Intensive
Direct materials per unit	$5.00	$6.00
Direct labor per unit	$5.00	$10.00
Variable manufacturing overhead per unit	$4.00	$2.00
Fixed manufacturing overhead per year	$2,440,000	$700,000
Variable selling Expense	$2.00	$2.00
Fixed selling expense	$500,000	$500,000
Selling price	$40	$40
Total unit variable cost	$16	$20
Unit contribution margin	$24	$20
Total fixed cost	$2,940,000	$1,200,000
Breakeven quantity	122,500	60,000

(b)

Determine the annual unit volume at which Sharpie is indifferent between the two manufacturing methods.
435,000 units.

Explanation:

Let the indifference volume be 'V' such that, 24 V - 2940000 = 20 V - 1200000
or, 4 V = 1740000
or, V = 435,000

(c)

Operating Leverage = Total contribution margin / Net income

It is positively correlated with the volatility of earnings, with increases in operating leverage accompanied by increases in the volatility of earnings.

2.

	Capital Intensive	Labor Intensive
Volume (V)	250,000	250,000
Unit contribution margin (C)	$24	$20
Total contribution margin (V.C)	$6,000,000	$5,000,000
Total fixed cost (F)	$2,940,000	$1,200,000
Net income (N = V.C - F)	$3,060,000	$3,800,000
Operating Leverage (N / V.C)	1.96	1.32

3.

The capital-intensive method has a higher operating leverage because of the greater use of fixed assets.