Question

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		$1,740,000		$1,740,000
Variable costs		1,392,000		696,000
Contribution margin		348,000		1,044,000
Fixed costs		108,000		804,000
Net income		$240,000		$240,000

(a)

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

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(b)

Calculate the increase in Net income for each alternative if sales increased by $142,000.

		Increase in Net Income
Manual System		$
Computerized System		$

Which alternative would produce the higher net income ?                                                                       Computerized SystemManual System

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(c)

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.                                                                       Computerized SystemManual System

Answer 1

A.)DEGREE OF OPERATING LEVERAGE

OPERATING LEVERAGE = CONTRIBUTION / EBIT

MANUAL COMPUTERIZED

348000/24000=1.45 1044000/240000=4.35

B.)SALES INCREASED BY 142000

MANUAL COMPUTERIZED

SALES 1882000 1882000

VARIABLE COST 1392000 696000

CONTRIBUTION 490000 1186000

FIXED COST 108000 804000

NET INCOME 382000 382000

C.) MARGIN OF SAFETY

MOS = PROFIT / PV RATIO

PV RATIO = CONTRIBUTION/ SALES

MANUAL COMPUTERIZED

348000/174000=.2 1044000/1740000=.6

MARGIN OF SAFETY

240000/.2= 1200000 240000/.6=400000