Question

For nearly 20 years, Specialized Coatings has provided painting and galvanizing services for manufacturers in its region. Manufacturers of various metal products have relied on the quality and quick turnaround time provided by Specialized Coatings and its 20 skilled employees. During the last year, as a result of a sharp upturn in the economy, the company’s sales have increased by 30% relative to the previous year. The company has not been able to increase its capacity fast enough, so Specialized Coatings has had to turn work away because it cannot keep up with customer requests. Top management is considering the purchase of a sophisticated robotic painting booth. The booth would represent a considerable move in the direction of automation versus manual labor. If Specialized Coatings purchases the booth, it would most likely lay off 15 of its skilled painters. To analyze the decision, the company compiled production information from the most recent year and then prepared a parallel compilation assuming that the company would purchase the new equipment and lay off the workers. Those data are shown below. As you can see, the company projects that during the last year it would have been far more profitable if it had used the automated approach. Current Approach Automated Approach Sales $2,040,000 $2,040,000 Variable costs 1,530,000 1,020,000 Contribution margin 510,000 1,020,000 Fixed costs 388,000 816,000 Net income $122,000 $204,000

Compute the contribution margin ratio under each approach. (Round ratios to 0 decimal places, e.g. 15%.) Current approach Automated approach Contribution margin ratio %.............. %..............

Compute the break-even point in sales dollars under each approach. Current approach Automated approach Break-even points in sales dollars $............ $............

Using the current level of sales, compute the margin of safety ratio under each approach. (Round ratios to 0 decimal places, e.g. 15%.) Current approach Automated approach Margin of safety ratio %........... %.............

Determine the degree of operating leverage for each approach at current sales levels. (Round answers to 2 decimal places, e.g. 2.25.) Current approach Automated approach Degree of operating leverage ………… ………….. How much would the company’s net income decline under each approach with a 10% decline in sales? (Round answers to 1 decimal place, e.g. 22.5%.) For a 10% drop in sales net income would ……. by ………. % for Current approach For a 10% drop in sales net income would ………. by ………… % for Automated approach

At what level of sales would the company’s net income be the same under either approach? Net income would be equal to………….. $ sales

Answer 1

Solution:

Part 1 – Contribution Margin Ratio

	Current	Automated
	Approach	Approach
Contribution margin (a)	510,000	1,020,000
Sales (b)	$2,040,000	$2,040,000
Contribution Margin Ratio (a/b x 100)	25.00%	50.00%

Part 2 --- Break Even Point in sales dollars

Break Even Point in sales dollars = Total Fixed Costs / Contribution Margin Ratio

	Current	Automated
	Approach	Approach
Total Fixed Costs (a)	388,000	816,000
Contribution Margin Ratio (b)	25%	50%
Break Even Point in sales dollars (a / b)	$1,552,000	$1,632,000

Part 3 – Margin of Safety

Margin of Safety = Total Sales – Break Even Sales in dollars

	Current	Automated
	Approach	Approach
Total Sales (a)	2,040,000	2,040,000
Break Even Point in sales dollars (b)	$1,552,000	$1,632,000
Margin of Safety (a - b)	$488,000	$408,000

Margin of Safety Ratio = Margin of Safety in dollar /Total Sales x 100

Current Approach = 488000 / 2040,000 x 100 = 23.92%

Automated Approach = 408000 / 2040000 x 100 = 20%

Part 4 – Degree of Operating Leverage

Degree of Operating Leverage = Contribution Margin / Net Income

	Current	Automated
	Approach	Approach
Contribution Margin (a)	510,000	1,020,000
Net Income (b)	$122,000	$204,000
Degree of Operating Leverage (a/b)	4.18	5.00

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