Question

Question 3 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 Sales Variable costs Contribution margin Fixed costs Net income $1,560,000 1,248,000 312,000 72,000 $240,000 Computerized System $1,560,000 624,000 936,000 696,000 $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 Calculate the increase in Net income for each alternative if sales increased by $119,000. Increase in Net Income Manual System Computerized System Which alternative would produce the higher net income?

Answer 1

Answer 1	Degree of Operating Leverage (DOL)
	Particulars	Manual System	Computerized System
	Sales	$                           15,60,000.00	$                             15,60,000.00
	Variable Costs	$                           12,48,000.00	$                               6,24,000.00
	Contribution Margin	$                              3,12,000.00	$                               9,36,000.00
	Fixed Costs	$                                 72,000.00	$                               6,96,000.00
	Net Income or EBIT*	$                              2,40,000.00	$                               2,40,000.00
	* EBIT (Earnings Before Interest and Tax)
	Operating Leverage =	Contribution / EBIT
	Contribution	$                              3,12,000.00	$                               9,36,000.00
	Net Income /EBIT	$                              2,40,000.00	$                               2,40,000.00
	Operating Leverage	1.30	3.90
	Degree of Operating Leverage (DOL)
=	Percentage change in EBIT/ Percentage change in Sales
	Put Value change in EBIT as a 'X' and Calculate value of 'X' as follows
	Operating Leverage (Times)	1.30	3.90
	Percentage change in Sales	EBIT / Sales
	EBIT (a)	$                              2,40,000.00	$                               2,40,000.00
	Sales (b)	$                           15,60,000.00	$                             15,60,000.00
	(In %) (a/b)	0.15	0.15
	Value of change EBIT	X	X
	EBIT	$                              2,40,000.00	$                               2,40,000.00
	Percentage change in EBIT	X /240,000	X /240,000
	Degree of Operating Leverage (DOL)
		1.3 times = (X /240,000)/.15	3.9 times = (X /240,000) /.15
		0.195 = 'X' / 240,000	0.585 = 'X' /240,000
		X = 240,000 * .195	X = 240,000 * .585
	X (a)	$                                 46,800.00	$                               1,40,400.00
	EBIT (b)	$                              2,40,000.00	$                               2,40,000.00
	Percentage change in EBIT (a/b)	0.20	0.59
	Degree of Operating Leverage (DOL)
	Percentage change in EBIT (a)	0.20	0.59
	Percentage change in Sales (b)	0.15	0.15
	Degree of Operating Leverage (DOL) (a/b)
		1.27	3.80

Answer 2	Increase in Net Income
	Particulars	Manual System	Computerized System
	Sales	$ 15,60,000.00	$ 15,60,000.00
	Increase in sales	$    1,19,000.00	$    1,19,000.00
	Total Sales (a)	$ 16,79,000.00	$ 16,79,000.00
	Variable Costs (Note 1)(b)	$ 13,43,200.00	$    6,71,600.00
	Contribution Margin c = (a-b)	$    3,35,800.00	$ 10,07,400.00
	Fixed Costs (d)	$       72,000.00	$    6,96,000.00
	Net Income or EBIT e = (c-d)	$    2,63,800.00	$    3,11,400.00
	Old Net Income (f)	$    2,40,000.00	$    2,40,000.00
	Increase in Net Income (e-f)	$       23,800.00	$       71,400.00
	Note
	Computerized system alternative produce more Net income. That $ 71,400. Compare to Manual system $47,600 excess is there.
	New Variable Costs (Note 1)
	Variable Costs (a)	$ 12,48,000.00	$    6,24,000.00
	Sales (b)	$ 15,60,000.00	$ 15,60,000.00
	Variable Costs ratio (a/b) in % (d)	0.80	0.40
	New Sales (e)	$ 16,79,000.00	$ 16,79,000.00
	New Variable Costs (e*d)	$ 13,43,200.00	$    6,71,600.00

Answer 3	Calculation of Margin of Safety Ratio on New Sales
	Equation are =	Profit / PV ratio
	PV ratio =	Sales - Variable cost /Sales
	Particulars	Manual System	Computerized System
	New Sales (a)	$ 16,79,000.00	$ 16,79,000.00
	New Variable Costs (b)	$ 13,43,200.00	$    6,71,600.00
	Contribution (c=a-b)	$    3,35,800.00	$ 10,07,400.00
	Fixed Cost (d)	$       72,000.00	$    6,96,000.00
	Net Income/Profit e=c-d)	$    2,63,800.00	$    3,11,400.00
	PV ratio =	Sales - Variable cost /Sales
	PV Ratio (f)	0.20	0.60
	Margin of Safety	Profit / PV ratio
	Margin of Safety Ratio (g =e/f)	$ 13,19,000.00	$    5,19,000.00
	Break even Sales	Fixed cost / PV Ratio
	Break even Sales h = (d/f)	$    3,60,000.00	$ 11,60,000.00
	Margin of Safety Ratio	Break even Sales / Sales
	Margin of Safety Ratio % (I=h/a)	0.21	0.69