Alternative Production Procedures and Operating Leverage (LO3, 5)

Assume Paper Mater is planning to introduce a new executive pen that can be manufactured using either a capital-intensive method of 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 $5.00 $12.00

Variable man. overhead per unit $4.00 $2.00

Fixed man. overhead per year $2,440,000 $700,000

Paper Mates market research department has recommended an introductory unit sales price of $30. The incremental selling costs are predicted to be $500,000 per year, plus $2 per unit sold.

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 250,000 units.

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