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:

Capital Intensive Labor Intensive

Direct materials per unit $5.00 $6.00

Direct labor per unit $5.0 $13.00

Variable manufacturing overhead per unit $5.00 $2.00

Fixed manufacturing overhead per year $2,580,000.00 $780,000.00

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.

Required

(a) Determine the annual break-even point in units if Paper Mate uses the:

1. Capital-intensive manufacturing method.

2. Labor-intensive manufacturing method.

(b) Determine the annual unit volume at which Paper Mate is indifferent between the two manufacturing methods.

(c) Management wants to know more about the effect of each alternative on operating leverage.

1. Explain operating leverage and the relationship between operating leverage and the volatility of earnings.

2. Compute operating leverage for each alternative at a volume of 260,000 units.Round your answers two decimal places.

3. Which alternative has the higher operating leverage? Why?