Question

E-Z Seats manufactures swivel seats for customized vans. It currently manufactures 10,000 seats per year, which it sells for $500 per seat. It incurs variable costs of $200 per seat and fixed costs of $2,000,000. It is considering automating the upholstery process, which is now largely manual. It estimates that if it does so, its fixed costs will be $3,000,000, and its variable costs will decline to $100 per seat.

The contribution margin ratio, break-even point in dollars, margin of safety ratio, and degree of operating leverage based on current activity is as follows:

Contribution margin ratio		60.00	%
Break-even point in dollars		$3333333
Margin of safety ratio		33.30	%
Degree of operating leverage		3.00

Assuming the new upholstery system is implemented the contribution margin ratio, break-even point in dollars, margin of safety ratio, and degree of operating leverage is as follows:

Contribution margin ratio		80.00	%
Break-even point in dollars		$3750000
Margin of safety ratio		25.00	%
Degree of operating leverage		4.00

(e)

Discuss the implications of adopting the new system.

Answer 1

By adopting the new system contribution margin ratio increases from 60% to 80% which shows that

% of sales revenue to cover the fixed cost increases from 60% to 80%.

Since the implementation of new system incurs fixed cost the breakeven sales increases from 3.3 million $ to 3.7 million $.

Also, the margin of safety decreases due to increase in breakeven sales which indicates that

if sales decrease by only 25% it will reach the breakeven levels whereas earlier it was 33.30%.

The degree of operating leverage increases which shows that effect of increase or decrease in sales

will be higher on the net income.