Question

Exercise 19-15 a-c 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 Computerized System Sales Variable costs Contribution margin Fixed costs $1,800,000 1,440,000 360,000 120,000 $240.000 $1,800,000 720,000 1,080,000 840,000 $240,000 Net income 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 $118,000. Increase in Net Income Manual System Computerized System

Answer 1

(a) Degree of operating leverage= Contribution margin/Net income

Manual system= $360000/240000= 1.5

Computerized system= $1080000/240000= 4.5

(b) Contribution margin ratio= Contribution margin*100/Sales

Manual system= $360000*100/1800000= 20%

Computerized system= $1080000*100/1800000= 60%

If sales is increased by $118000, the net income for each alternative will increases by

	Increase in net income
Manual system ($118000*20%)	$23600
Computerized system ($118000*60%)	$70800

Computerized system will produce the higher net income as the net income of Computerized system is greater than Manual system

(c) Break even sales= Fixed cost/Contribution margin ratio

Manual system= $120000/20%= $600000

Computerized system= $840000/60%= $1400000

Margin of safety= Actual sales-Break even sales

Manual system= $1800000-600000= $1200000

Computerized system= $1800000-1400000= $400000

Margin of safety ratio= Margin of safety/Actual sales

Manual system= $1200000/1800000= 0.67

Computerized system= $400000/1800000= 0.22

Using the margin of safety ratio, Manual system alternative will sustain the greater decline in sales before operating a loss as the margin of safety ration of manual system is greater than the computerized system.