Question

3-30 Operating leverage. Cover Rugs is holding a 2-week carpet sale at Josh's Club, a local warehouse store. Cover Rugs plans to sell carpets for $950 each. The company will purchase the carpets from a local distributor for $760 each, with the privilege of returning any unsold units for a full refund. Josh's Club has offered Cover Rugs two payment alternatives for the use of space. Option 1: A fixed payment of $7,410 for the sale period . Option 2: 10% of total revenues earned during the sale period

Answer 1

44 1. Calculate the breakeven point in units for (a) Option 1 and (b) Option 45 Break even point for option 1: Sales- Variable cost= Fixed cost 46 47 48 Let X denotes the quantity of Carpets sold 49 50 950 * X - 760 *X 7410 51 52 190*X 7410 53 54 х 7410 190 55 56 57 х = 39 Carpets 58

59 Breakeven point for Option 2 Sales- variable cost-rent cost=0 60 61 950 * X - 760 *X - (950*x*10%) = 0 62 63 95 *X 0 64 х 11 0 65 66 67 95 68 X = O Carpets 69

70 2. At what level of revenues will Cover Rugs earn the same operating income under either option? 71 a. For what range of unit sales will Cover Rugs prefer Option 1? 72 73 Level of sales for same operating income Difference in Fixed costs Difference in contribution Margin 74 75 76 7410 77 (950*10%) 78 79 7410 95 80 81 82 83 78 Carpets 84 If Q> 78 ,suppose 79 85 Option 2 86 Option 1 15010 7410 Contribution Margin (950-760) *79 Less Fixed Cost Operating Income 7505 (950-760-95)*79 0 87 88 7600 7505 89

90 As Operating income of Option 1 is higher , therefore Color Rugs will prefer Option 1 91 92 If Q< 78,suppose 77 93 Option 2 94 Option 1 14630 7410 Contribution Margin (950-760) *77 Less Fixed Cost Operating Income 7315 (950-760-95)*77 0 95 96 7220 7315 97 98 As Operating income of Option 2is higher , therefore Color Rugs will prefer Option 2 99 100 3. Calculate the degree of operating leverage at sales of 65 units for the two rental options. 101 102 Option 1 Option 2 103 104 Degree of Operating leverage Contribution Margin Operating Income 95*65 190*65 190*65-7410 105 95*65 106 6175 12350 4940 6175 107 108 109 110 111 Degree of Operating leverage 2.50 1.00

112 4. Briefly explain and interpret your answer to requirement 3. 113 114 115 Degree of Operating leverage of option 1 is 2.5 whereas for option 2 it is 1. Degree of Operating leverage at a given level of saleshelps managers in calculating the effect of fluctuations in sales on operating incomes. 116 117 118