Breakeven Point – Fixed Expenses / Contribution Margin Ratio Current Approach: 200,000 / .4 = $500,000
Automated Approach:600,000 / .8 = $750,000
The current approach without investing in the new robotic painting booth has a higher margin of safety (Total Sales- Breakeven sales = Margin of safety. Current: $2,000,000 – $500,000 = $1,500,000
Automated: $2,0000,000 – $750,000 = $1,250,000
Using the current approach, they cannot increase capacity and would have to turn sales away. As long as they are beyond the break-even of 500,000 for the automated approach, they can improve their sales and possibly their contribution margin and gross margin with purchasing the robot painting booth. On the down side, they would have to possibly lay off 25 of their skilled painters, which is not good for the community where the business is located.
(c) Using the current level of sales, compute the margin of safety ratio under each approach and interpret your findings.
Current ApproachAutomated Approach
Margin of Safety Ratio0.750.625
(Actual Sales- Break-Even Sales)/Actual Sales= Margin of Safety Ratio The purpose of margin of safety ratio is to evaluate the relative impact if the changes in sales would have on each approach. The difference in the ratio represents the difference in risks between Current and Automated Approach. To find the ratio, we use actual sales minus the break-even sales; the result is the margin safety ratio. Generally speaking, this ratio is the lower the better because it indicates the risk of operating loss; in this case, the Automated Approach is more favorable to the company.
(d) Determine the degree of operating leverage for each approach at current sales levels. How much would the company’s net income decline under each approach with a 10% decline in sales?
Current ApproachAutomated Approach
Degree of Operating Leverage1.331.60
Contribution Margin/ Net Income= Degree of Operating Leverage We find the degree by using contribution margin / Net Income of each approach; the results are the degree of operating leverage. This approach is important to the decision makers because the analysis indicates the earnings volatility; in general, higher operating leverage indicates a higher earnings volatility risk. The degree of operating leverage is an important tool aiming the company to know the behaviors of its competitors; as well as the comparison of two approaches if the management considering to adopt a new approach to replace the existing one. Assume the net income of each approach decline with a 10% decline in sales, the net income under Current Approach will reduce by 13.3% (1.33*10%), and the net income under the automated approach will decrease by 16% (1.60*10%). The conclusion is Automated Approach exposes to a higher earnings volatility risk because it has a higher operating leverage.
(e) At what level of sales would the company’s net income be the same under either approach?
The level of sales that the company’s net income would be the same under either approach is $1,000,000. .6x + 200,000 = .2x + 600,000
.8x = 800,000
x = $1,000,000
(f) Discuss the issues that the company must consider in making this decision. Many items need to be considered before the company makes a decision. The automated approach has a lower margin of safety should sales decline meaning the company would lose money quicker than if it remain under the original approach. The operating leverage is also higher under the automated approach. All of the calculations indicate a greater risk to the company under the automated approach, but as often happens this is the approach that also offers the greatest potential for profits if sales continue to grow. These risks need to be weighed carefully to protect the company’s income.