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 material per unit	$5.00	$8.00
Direct Labor per unit	$5.00	$12.00
Variable manucfacture overhead per unit	$4.00	$2.00
Fixed manufacuring overhead per year	$2,440,000.00	$700,000.00

Paper Mates market research department has recommended an introductory unit sales price of

$40. 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 manu-

facturing 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 vola-

tility of earnings.

2. Compute operating leverage for each alternative at a volume of 250,000 units.

3. Which alternative has the higher operating leverage? Why