Imagen Arquitectonica of Tijuana, Mexico is contemplating a major change in its cost structure. Currently, all of its drafting work is performed by skilled draftsmen. Alfredo Ayala, Imagen's owner, is considering replacing the draftsmen with a computerized drafting system.
However, before making the change Alfredo 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 $1,500,000 $1,500,000
Variable costs
1,200,000
600,000
Contribution margin 300,000 900,000
Fixed costs
60,000
660,000
Net income
$240,000
$240,000
Determine the degree of operating leverage for each alternative. (Round answers to 2 decimal places, e.g. 10.50.)
Manual System
Computerized System
Which alternative would produce the higher net income if sales increased by $100,000?
Using the margin of safety ratio, determine which alternative could sustain the greater decline in sales before operating at a loss.
To determine the degree of operating leverage for each alternative, we can use the formula:
Degree of Operating Leverage = Contribution Margin / Net Income
For the Manual System:
Degree of Operating Leverage = $300,000 / $240,000 = 1.25
For the Computerized System:
Degree of Operating Leverage = $900,000 / $240,000 = 3.75
Now, let's determine which alternative would produce the higher net income if sales increased by $100,000.
For the Manual System:
Net Income = $240,000 + ($100,000 * Degree of Operating Leverage)
Net Income = $240,000 + ($100,000 * 1.25)
Net Income = $240,000 + $125,000
Net Income = $365,000
For the Computerized System:
Net Income = $240,000 + ($100,000 * Degree of Operating Leverage)
Net Income = $240,000 + ($100,000 * 3.75)
Net Income = $240,000 + $375,000
Net Income = $615,000
Therefore, the Computerized System would produce the higher net income if sales increased by $100,000.
Next, let's use the margin of safety ratio to determine which alternative could sustain the greater decline in sales before operating at a loss. The margin of safety ratio is calculated as:
Margin of Safety Ratio = (Actual Sales - Break-even Sales) / Actual Sales
For the Manual System:
Margin of Safety Ratio = ($1,500,000 - $60,000) / $1,500,000
Margin of Safety Ratio = $1,440,000 / $1,500,000
Margin of Safety Ratio = 0.96
For the Computerized System:
Margin of Safety Ratio = ($1,500,000 - $660,000) / $1,500,000
Margin of Safety Ratio = $840,000 / $1,500,000
Margin of Safety Ratio = 0.56
Therefore, the Manual System has a higher margin of safety ratio, indicating that it can sustain a greater decline in sales before operating at a loss.
In summary:
- The Computerized System would produce the higher net income if sales increased by $100,000.
- The Manual System could sustain a greater decline in sales before operating at a loss, based on its higher margin of safety ratio.