Question

Number 6 employeeplacing Testy Time Cafeteria operates cafeteria food services in public buildings in the Midwest Tasty Time is contemplating a major change in its cost structure. Currently, all of their cafeteria lines are staffed with hourly wage employees who hand serve the food to customers. Benson Riggs Tasty Time's owner, is considering replacing the employees with an automated self-service system. However, before making the change, Benson would like to know the consequences of the change, since the volume of business varies significantly from location to location. Shown below are the CVP income statements for each alternative. Bensorficante (b) Personal Service Automated Self-Service System System Sales $2,500,000 $2,500,000 Variable costs 1.875.000 1.125.000 Contribution margin $ 625,000 $1,375,000 Fixed costs 125.000 875.000 Net Income $500,000 $ 500.000 Instructions (a) Determine the degree of operating leverage for each alternative. Which alternative would produce the higher net income if sales increased by $250,000? Using the margin of safety ratio, determine which alternative could sustain the greater decline in sales before operating at a loss. Tasty Time's vice president of finance has offered another option. He suggests a different system that combines personal service at key points in the cafeteria line with a less expensive automated self-service system for the other items. The financial information on this system is given below: Blended Service System Sales $2,500,000 Variable costs 1.500.000 Contribution margin $ 1.000.000 Fixed costs Net Income $ 500.000 500.000 (2) (3) Determine the degree of operating leverage for this option. How much would net income increase if sales increased by $250,000? Using the margin of safety ratio, how large of a decline in sales could this option sustain before operating at a loss. Which option do you recommend for Tasty Time Cafeteria?

Answer 1

(a)

Income Statement

Particulars	Personal Service	Automated Service
Sales	2,500,000	2,500,000
Variable Cost	1,875,000	1,125,000
Contribution	625,000	1,375,000
Fixed Cost	125,000	875,000
Net Income	500,000	500,000
Degree of Operating Leverage (Contribution/Net Income)	1.25	2.75

(b) Since the Automated Service option has higher Operating leverage hence it is more vulnerable to change in sales. In other words, an increase in sales would yield higher net income in this case.

(c) Margin of Safety ratio = (Current Sales - Break-even Sales)/Current Sales

Break-even Sales = Fixed Cost/Contribution ratio

As calculated above, the Personal Service option could survive a greater decline in sales, in comparison to an Automated Service option.

(d)

(2) Increase in Net Income if Sales increase by $ 250,000 = Increase in Sales*Contribution Ratio

=> 250,000*40% = $ 100,000

Hence increase in Net Income = $ 100,000

(3) Margin of Safety Sales = Current Sales - Break-Even Sales

=> 2,500,000 - (Fixed Cost/Contribution ratio)

=> 2,500,000 - (500,000/40%)

=> 1,250,000

Hence the company could survive the decline of up to 50% from the current levels.

(4) In my view, the company should adopt Blended Service System as it offers higher returns in comparison to Personal Service system and also because of the following business regions;

a. The Blended system is less vulnerable to change in sales in comparison to the Automated Service System. A new system could be difficult to adopt by the existing customers.

b. The Blended System includes both Personal and Automated System, thus helping the company in analysing the shift of technology better, guiding the existing customers about the change and also in retaining existing customers.

c.Further, the company would gradually gain the goodwill on account of making changes in its traditional system.