Question

Tasty 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. Sales Variable costs Contribution margin Fixed costs Net Income Personal Service Automated Self-Service System System $1,990,000 $1,990,000 1,492,500 995,000 $497,500 $995,000 99,500 597,000 $398,000 $398,000 Your answer is correct. Determine the degree of operating leverage for each alternative. (Round answers to 2 decimal places, e.g. 15.25.) Personal Service System Automated Self-Service System 2.50 Operating leverage 1.25

Answer 1

Net income at current sales level = $398,000

If the sales are increased by $199,000 (i.e. 10% increase in sale), the contribution margin will also increase by 10% i.e. $79,600 (10% of present contribution margin). However, the fixed costs are already recovered from the current contribution margin, the increased sales will result in additional operating income that will be equivalent to the additional contribution margin. Hence, Net income will increase by $79,600

% increase in net income = Increase in net income / Net income at current sales level

= $79,600 / $398,000

= 20%

Contribution Margin (%) = Contribution margin / Sales

= $1,194,000 / $1,990,000

= 60% or 0.6

Margin of safety ($) = Fixed cost / (1 - Contribution Margin ratio)

= $398,000 / (1 - 0.6)

= $995,000

Margin of safety ratio = Margin of Safety ($) / Sales ($)

= $995,000 / $1,990,000

= 0.5