Question

Exercise 6-15 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 $1,620,000 1,296,000 324,000 84,000 $240,000 Computerized System $1,620,000 648,000 972,000 732,000 $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 $140,000. Increase in Net Income Manual System Computerized System Which alternative would produce the higher net income? Calculate the margin of safety ratio. (Round ratios to 2 decimal places, e.g. 0.25.) Margin of Safety ratio Manual System Computerized System Using the margin of safety ratio, determine which alternative could sustain the greater decline in sales before operating at a loss.

Answer 1

1. Degree of operating leverage = Contribution / net income

Manual = $324000/$240000 = 1.35

Computerized = $972000/$240000 = 4.05

2. Increase in net income

= Additional sales * contribution ratio

Manual system = $140000*20% = $28000

Computerized system = $140000*60% = $84000

Computerized system generates a higher income.

3. Margin of safety = profit / contribution ratio

Manual system = $240000/20% = $1200000

Computerized system = $240000/60% = $400000

MOS ratio = MOS sales / total sales * 100

Manual = $1200000/$1620000*100 = 0.74

Computerized = $400000/$1620000*100 = 0.25

Manually system Will suffer greater decline in sales because of a lower contribution ratio

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