Alternative Production Procedures and Operating Leverage Assume Paper Mate is pl

Question

Alternative Production Procedures and Operating Leverage

Assume Paper Mate is planning to introduce a new executive pen that can be manufactured using either a capital-intensive method or a labor-intensive method. the predicted manufacturing costs for each method are as follows:

Alternative Production Procedures and Operating Leverage Assume Paper Mate is planning to introduce a new executive pen that can be manufactured using either a capital-intensive method or a labor-intensive method. The predicted manufacturing costs for each method are as follows: Direct materials per unit Direct labor per unit Variable manufacturing overhead per unit Flxed manufacturing overhead per year Capital Intensive Labor Intensive $6.00 $13.00 $2.00 $780,000.00 $5.00 $5.00 $5.00 $2,580,000.00 Paper Mate's market research department has recommended an introductory unit sales price of $31. The incremental selling costs are predicted to be $500,000 per year, plus $2 per unit sold. (a) Determine the annual break-even point in units if Paper Mate uses the 1. Capital-intensive manufacturing method. 0 units 2. Labor-intensive manufacturing method 0 units (b) Determine the annual unit volume at which Paper Mate is indifferent between the two manufacturing methods. 0 units

Explanation / Answer

Solution a:

Total fixed cost - Capital intensive = $2,580,000 + $500,000 = $3,080,000

Total fixed cost - Labor intensive = $780,000 + $500,000 = $1,280,000

Breakeven point if Paper mate use capital intensive method = Fixed cost / contribution margin per unit

= $3,080,000 / $14 = 220000 units

Breakeven point if Paper mate use labor intensive method = Fixed cost / contribution margin per unit

= $1,280,000 / $8 = 160000 units

Solution b:

Let at X unit volume paper mate is indifferent between the two manufacturing methods.

Now at x units profit under both methods will be same.

Therefore

$14 X - $3,080,000 = $8X - $1,280,000

6X = $1,800,000

X = 300000 units

Solution c1:

Operating leverage and volatility of earnings are postively corelated, with increase in operating leverage accompanied by increase in volatility of earnings.

Solution c2:

Capital intensive operating leverage = Contribution / Net operating income = $3,640,000 / $560,000 = 6.5

Labor intensive operating leverage = $2,080,000 / $800,000 = 2.6

Solution c3:

The capital intensive method has a higher operating leverage because of greater use of fixed assets

Computation of contribution margin per unit - Paper Mate Particulars Capital Intensive Labor Intensive Selling price per unit $31.00 $31.00 Variable cost per unit: Direct material $5.00 $6.00 Direct labor $5.00 $13.00 Variable manufacturing overhead $5.00 $2.00 Variable selling expenses $2.00 $2.00 Total variable cost per unit $17.00 $23.00 Contribution margin per unit $14.00 $8.00

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