E3-17 (similar to) O'Reilly Manufacturing sold 445 comma 000 units of its product for $ 62 per unit in 2014. Variable cost per unit is $ 50 , and total fixed costs are $ 1 comma 780 comma 000. Requirements 1. Calculate (a) contribution margin and (b) operating income. 2. O'Reilly 's current manufacturing process is labor intensive. Kate Wagner , O'Reilly 's production manager, has proposed investing in state-of-the-art manufacturing equipment, which will increase the annual fixed costs to $ 5 comma 340 comma 000. The variable costs are expected to decrease to $ 48 per unit. O'Reilly expects to maintain the same sales volume and selling price next year. How would acceptance of Wagner 's proposal affect your answers to (a) and (b) in requirement 1? 3. Should O'Reilly accept Wagner 's proposal? Explain.

1. a. Contribution Margin is $5,340,000

1. b. Operating income is $3,560,000

2. a. Contribution Margin will increase to $6,230,000

2. b. Operating income will decrease to $890,000

3. YES

Explanation:

1a. Contribution margin is the difference between Sales and variable expense.

Sales (445,000 x $62) $27,590,000

Variable expense (445,000 x $50) ($22,250,000)

Contribution Margin $5,340,000

1b. Operating income is the difference between contribution margin and the total fixed costs. It is the amount we derived after we deduct all operating expenses. Based on the contribution margin we computed above, we can now readily compute the operating income.

Contribution margin $5,340,000

Fixed Costs ($1,780,000)

Operating profit $3,560,000

2a. If O'Reilly will invest on the equipment, the following effect on contribution margin is;

Sales (445,000 x $62) $27,590,000

Variable cost (445,000 x $48) $21,360,000

Contribution margin $6,230,000

From $3,560,000 the contribution margin will increase to $6,230,000

2b. The effect on operating income after the investment will be;

Contribution margin (based on new cost) $6,230,000

Less: Fixed cost (if the equipment is acquired) $5,340,000

Operating income $890,000

*After O'Reilly will consider on acquiring the new equipment, their operating income will decrease to $890,000 from $1,780,000. In effect a decrease of $890,000 will happen if the company will consider to invest the new equipment.

3. NO, O'Reilly should accept the investment of new equipment by Kate Wagner, though the company will suffer a decrease in the total operating income due to material increase in the fixed cost, their contribution margin has increased by $890,000 that covers the 200% increase in the total fixed cost. After the effect on the first year, said equipment will cause an increase in the total income of the company due to the reduction of variable cost after it will be acquired.