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27 December, 13:20

Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine with a fixed cost (mainly depreciation) of $17,000 and variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sales price per deck would be the same under each method. At what unit output level would the two methods provide the same operating income (EBIT) ?

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  1. 27 December, 13:57
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    24,000 units

    Explanation:

    We know,

    According to the contribution margin approach,

    Operating Income (EBIT) = Sales - Variable cost - Fixed cost

    or, EBIT = (Price x Quantity) - (Quantity x VC per unit) - Fixed cost

    As there are two methods,

    Method 1, Variable cost = $1.00/unit, Fixed cost = $17,000

    Method 2, Variable cost = $1.50/unit, Fixed cost = $5,000

    According to the Question, as both methods will yield same EBIT at the same output levels,

    Method 1 EBIT = Method 2 EBIT

    or, (Price x Quantity) - (Quantity x $1.00) - 17,000 = (Price x Quantity) - (Quantity x $1.50) - $5,000

    or, (Quantity x $1.50) - (Quantity x $1.00) = $ (17,000 - 5,000) [Deducted (price x quantity from both the sides]

    or, $0.50 x Quantity = $12,000

    or, Quantity = $12,000/$0.50

    Hence, Quantity = 24,000 units

    At 24,000 output level, the EBIT of both methods will be same.
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