Upscale Hides sells its only product, a leather coat for $3,000 each. The produc

Question

Upscale Hides sells its only product, a leather coat for $3,000 each. The production process is highly labor intensive with almost the entire coat being hand cut and stitched by a single craftsmen. Currently the company's very skilled craftsmen are paid on a finished coat basis. Current variable costs (including labor) per coat are $1,200 and total fixed operating costs for the company are $4,000,000. Fixed interest charges are $500,000.

Upscale is contemplating a change in how it pays its craftsmen. If they are each paid a guaranteed fixed annual salary, total fixed operating costs will rise to $6,400,000 but variable costs per coat will drop to only $400 a coat.

{a} Compute the degree of operating leverage at a sales level of $9,000,000 under both the present pay system and the proposed new one.

{b} Explain why there is a difference between your two values in {a}.

{c} How does the forecasted volatility of future years' sales impact Upscale's decision?

Explanation / Answer

a)

Degree of operating leverage = contribution margin/net income

present system            = 5,400,000/900,000

                                  = 6

proposed system        =7,800,000/900,000

                                  =8.67

b)even the operating (net income) is same under both alternative but there contribution margin ratio differs.this is the reason for change in degree of operating leverage.

c) if there is a say 15% increase in sale , then the operating income will increase by 90% =(15%*6) under present system and by 130.05%   (15%*8.67) under proposed system.

present system proposed system sales 9,000,000 9,000,000 less:Variable cost at 3000coats (3,600,000) (1,200,000) contribution margin (A) 5,400,000 7,800.000 less:Fixed cost total operating expenses (4,000,000) (6,400,000) fixed interest charges (500,000) (500,000) total fixed cost(B) 4,500,000 6,900,000 net income (A-B) 900,000 900,000

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