Question

Canton Corp. produces a part using an expensive proprietary machine that can only be leased. The leasing company offers two contracts. The first (unit-rate lease) is one where Canton would pay $22 per unit produced, regardless of the number of units. The second lease option (flat-rate lease) is one where Canton would pay $330,000 per month, regardless of the number produced. The lease will run one year and the lease option chosen cannot be changed during the lease. All other lease terms are the same. The part sells for $220 per unit and unit variable cost (excluding any machine lease costs) are $110. Monthly fixed costs (excluding any machine lease costs) are $572,000. Required: a. What is the monthly break-even level assuming: 1. The unit-rate lease? 2. The flat-rate lease? b. At what volume would the operating profit be the same regardless of the lease option chosen? c. Assume monthly volume of 29,000 units. What is the operating leverage assuming: 1. The unit-rate lease? 2. The flat-rate lease? d. Assume monthly volume of 29,000 units. What is the margin of safety percentage assuming: 1. The unit-rate lease? 2. The flat-rate lease?

Answer 1

a) 1. Unit rate lease: Compute monthly breakeven level Unit Contribution margin=Unit Selling price- Unit vari able cost =$220-($110+$22) =$220-$132 =$88 Fixedcost Break even point (units) Contribution margin per unit $572,000 $88 6,500 2. Flat rate lease: Compute monthly breakeven level

Unit Contributi on margin=Unit Selling price-Unit variable cost =$220-$110 =S110 Fixedcost Break even point (units) Contributi on margin per unit S572,000+$330000 $110 8, 200 b) Let at Xunits produced profit margin is same under both the lease options

220X -132X-572,000=220X-110X-902,000 88X-572,000=110X-902,000 110X-88X=902,000 -572,000 330,000 X=: 22 =15,000 Hence, if 15,000 units are produced , profit margin will be same under both the lease options. c) 1. Unit rate lease: Prepare contribution margin Income statement Amount Sales (29,000 x $220) Less: Variable cost (29,000 x $132) Contribution margin Less: Fixed cost $6,380,000 $3,828,000 $2,552,000 $572,000 Operating Income $1,980,000

Compute operating leverage as follows: Contribution margin Operating Income Operatingleverage=: $2,552,000 $1,980,000 1.29 %3D 2. Flat rate lease Prepare contribution margin Income statement Amount Sales (29,000 x $220) Less: Variable cost (29,000 x $110) Contribution margin Less: Fixed cost Operating Income $6,380,000 $3,190,000 $3,190,000 $902,000 $2,288.000

Compute operating leverage as follows: Contribution margin Operating Income Operating leverage=. S3,190,000 $2,288,000 |1.40 d) 1. Unit rate lease Margin of safety = Actual Sales -Break even sales = (29,000x$220)-(6,500x$220) %3D =S6,380,000 -S1,430,000 =$4,950,000

Margin of safety (%)= Margin of safety Actual sales $4,950,000 S6,380,000 = 77.5% 2. Flat rate lease Margin of safety = Actual Sales -Break even sales = (29,000x$220)-(8,200x$220) %3D =$6,380,000 -$1,804,000 =S4,576,000 Margin of safety Margin of safety (%): Actual sales $4,576,000 S6,380,000 = 71.8%