C6.70

For nearly 20 years, Custom Coatings has provided painting and galvanizing services for manufacturers in its region. Manufacturers of various metal products have relied on the quality and quick turnaround time provided by Custom Coatings and its 20 skilled employees. During the last year, as a result of a sharp upturn in the economy, the company's sales have increased by 30% relative to the previous year. The company has not been able to increase its capacity fast enough, so Custom Coatings has had to turn work away because it cannot keep up with customer requests.

Top management is considering the purchase of a sophisticated robotic painting booth. The booth would represent a considerable move in the direction of automation versus manual labour. If Custom Coatings purchases the booth, it would most likely lay off 15 of its skilled painters. To analyze the decision, the company compiled production information from the most recent year and then prepared a parallel compilation assuming that the company would purchase the new equipment and lay off the workers. The data are shown at right. As you can see, the company projects that during the last year it would have been far more profitable if it had used the automated approach.

Current Approach

Automated Approach

Sales

$2,000,000

$2,000,000

Variable costs

1,200,000

400,000

Contribution margin

800,000

1,600,000

Fixed costs

200,000

600,000

Operating income

$600,000

$1,000,000

Instructions

a.

Calculate and interpret the contribution margin ratio under each approach.

b.

Calculate the break-even point in sales dollars under each approach. Discuss the implications of your findings.

c.

Using the current level of sales, calculate the margin of safety ratio under each approach and interpret your findings.

d.

Determine the degree of operating leverage for each approach at current sales levels. Calculate how much the company's operating income would decline under either approach with a 10% decline in sales.

e.

Determine at what level of sales the company's operating income would be the same under either approach.

f.

Discuss the issues that the company must consider in making this decision.