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	$ 8.00
Direct labor per unit	$ 5.00	$ 12.00
Variable manufacturing overhead per unit	$ 4.00	$ 2.00
Fixed manufacturing overhead per year	$ 2,440,000	$ 700,000

Paper Mate's 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.

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

1. Capital-intensive manufacturing method.

Answer

units

2. Labor-intensive manufacturing method.

Answer

units

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

Answer

units

(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.

They have little or no correlation because they are unrelated.

They are positively correlated, with increases in operating leverage accompanied by increases in the volatility of earnings.

They are negatively correlated, with increases in operating leverage accompanied by decreases in the volatility of earnings.

2. Compute operating leverage for each alternative at a volume of 250,000 units. Round your answers two decimal places.

Capital-Intensive operating leverage

Answer

Labor-Intensive operating leverage

Answer

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

The labor intensive method has a higher operating leverage because of higher variable conversion costs.

The labor intensive method has a higher operating leverage because of lower variable manufacturing overhead.

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

The capital intensive method has a higher operating leverage because of the higher variable manufacturing overhead.