COST-VOLUME PROFIT ANALYSIS

For nearly 20 years, Specialized Coating 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 Specialize 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 Specialized 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 labor. If Specialized
Coatings purchases the booth, it would most likely lay off 15 of its skilled painters. To analyse 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. Those data are show below. As you can see, the company projects that during the last year it
would have been far more profitable if its had used the automated approach.

Current Approach Automated Approach

Sales $2,000,000 $2,000,000
Variable costs 1,500,000 1,000,000
Contribution margin 500,000 1,000,000
Fixed costs 380,000 800,000
Net income $ 120,000 $ 200,000
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Instructions
1. Compute and interpret the contribution margin ratio under each approach.
CA 500/2000 = .25

AA 1000/2000 = .5

The contribution margin for the current approach is 25% ($500,000/$2,000,000). The
contribution margin for the automated approach would be 50% ($1,000,000/$2,000000)

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

CA
380K/.25 = 1,520,000

AA

800/.5 = 1M
 Under the current approach the breakeven point in sales dollars is $1,520,000
($380,000/.25). Under the automated approach the breakeven point in sales is $
1,600,000 ($800,000/.5). If this were the only consideration, it may appear that the
current approach provides the better opportunity to achieve profits, however the
breakeven point has not factored in the variable cost of the labor. The other
consideration is how long the equipment will be depreciated for. The fixed costs of the
equipment temporarily raise the contribution margin

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

THE MARGIN OF SAFETY FOR THE CURRENT APPROACH IS 24% ($2,000,000-

$1,520,000=$480,000/$2,000,000). The margin of safety for the automated approach is
20% ($2,000,000$1,600,000=$400,000/$2,000,000). According to this fact the current
approach is better because their sales could drop by $80,000 more than the automated
approach before the company has to worry about losing money.

4. Determine the degree of operating leverage for each approach at current sales levels. How
much would the company’s net income decline under each approach with a 10% decline in sales?

The degree of operating leverage for the current approach is 4.17 ($500,000/$120,000).
The degree of operating leverage for the automated approach is 5
($1,000,000/$200,000). If the company's sales dropped 10%, then their net income
would drop by 41.7% under the current approach and 50% under the automated
approach
5. At what level of sales would the company’s net income be the same under either approach?

If the company's sales dropped 10%, then their net income would drop by 41.7% under
the current approach and 50% under the automated approach

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

The company has to consider many factors before making this decision. First,
management would need to consider a long-term sales plan. In order for the robotic
painting booth to benefit the company’s income, they need to be sure that they can
increase sales for the company. Because a drop in sales would have a larger negative
impact on net income under the proposed automated method, the company should
address plans to ensure an increase to sales. Second, the company should do a thorough
analysis of its employees before making any decisions to reduce staff. Since the
anticipated staff reduction would impact 75% of the current staff, the company should
consider the positions that will remain necessary after automation and retain the highest
talent for those jobs. In addition, workforce reductions often lead to negative feelings
about a company from the community in which it operates. There could be an impact,
albeit temporary, to sales and income as a result of this. Lastly, the company should
consider purchasing option for the robotic painting booth. If a loan is necessary, are the
terms favorable? Will they be tying up a large amount of liquidity to make the
purchase? The impact of both to the company’s financials could be significant.