Question

Imagen Arquitectónica of Tijuana, Mexico, is contemplating a major change in its cost structure. Currently, all of its drafting work is performed by skilled draftspersons. Alfredo Ayala, Imagen’s owner, is considering replacing the draftspersons with a computerized drafting system.

However, before making the change, Alfredo would like to know its consequences, since the volume of business varies significantly from year to year. Shown below are CVP income statements for each alternative:

		Manual System				Computerized System
Sales			$1,100,000				$1,100,000
Variable costs			880,000				660,000
Contribution margin			220,000				440,000
Fixed costs			110,000				330,000
Operating income			$110,000				$110,000

Determine the degree of operating leverage for each alternative. (Round answer to 2 decimal places, e.g. 15.25.)

		Operating leverage
Manual System		enter the degree of operating leverage rounded to 2 decimal places
Computerized System		enter the degree of operating leverage rounded to 2 decimal places

Calculate which alternative would produce the higher operating income if sales increased by $110,000.

select an alternative                                                                      Computerized SystemManual System

would produce a higher operating income.

Using the margin of safety ratio, determine which alternative could sustain the greater decline in sales before operating at a loss. (Round margin of safety ratio to 2 decimal places, e.g. 15.25%.)

		Margin of Safety Ratio
Manual		enter percentages rounded to 2 decimal places %
Computerized		enter percentages rounded to 2 decimal places %

select an alternative                                                                      Computerized SystemManual System

could sustain the greater decline in sales before operating at a loss.

Answer 1

a
	Degree of Operating Leverage
Manual System	2.00
Computerized System	4.00
b
Computerized System produce the higher operating income
c
	Margin of Safety ratio
Manual System	50.00%
Computerized System	25.00%
Manual System could sustain the greater decline in sales

Workings:
	Manual System	Computerized System
Contribution margin	220000	440000
Divide by sales	1100000	1100000
Contribution margin ratio	20%	40%
	Manual System	Computerized System
Contribution margin	220000	440000
Divide by Operating income	110000	110000
Degree of Operating Leverage	2.00	4.00
	Manual System	Computerized System
Increase in sales	110000	110000
X Contribution margin ratio	20%	40%
Increase in Operating Income	22000	44000
	Manual System	Computerized System
Fixed costs	110000	330000
/ Contribution margin ratio	20%	40%
Break even sales	550000	825000
	Manual System	Computerized System
Sales	1100000	1100000
Less: Break even sales	550000	825000
Margin of Safety sales	550000	275000
	Manual System	Computerized System
Margin of Safety sales	550000	275000
Divide by Sales	1100000	1100000
Margin of Safety ratio	50.00%	25.00%