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 $8 per unit produced, regardless of the number of units. The second lease option (flat-rate lease) is one where Canton would pay $120,000 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 $80 per unit and unit variable cost (excluding any machine lease costs) are $40. Monthly fixed costs (excluding any machine lease costs) are $307,200. 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 22,000 units. What is the operating leverage assuming: 1. The unit-rate lease? 2. The flat-rate lease? d. Assume monthly volume of 22,000 units. What is the margin of safety percentage assuming: 1. The unit-rate lease? 2. The flat-rate lease?

Answer 1

Solution

a)

1. Unit Rate Lease = Unit selling price - Unit Variable cost

= $80- ($40+$8)

= $32

Break Even Point (Units) = Fixed cost

Contribution margin per unit

= $307,200

$32

=9,600 units

2. Flat Rate Lease = Compute monthly breakeven level

Unit contribution margin    = Unit selling price-Unit variable cost

= $80-$40 = $40

Break Even Point (Units) = Fixed cost

Contribution margin per unit

= $307,200+$120,000 =$10,680 units

$40

b) Let at X units produced profit margin is same under both the lease options

$80X-$48X-$307,200 = $80X-$40X-$427200

$32X-$307,200= $40X-$427,200

- $8X = -120,000

X=15,000 Units

Hence if 15,000 units are produced, profit margin will be same under both options

c)

1. Unit Rate Lease:

Prepare contribution margin income statement

  

Particulars	Amount ($)
Sales (22,000 units x $80)	17,60,000
Less-Variable cost (22,000 x $48)	10,56,000
Contribution Margin	704,000
Less Fixed cost	307,200
Operating Income	396,800

Computing Operating leverage as follows:

Operating leverage = Contribution margin

Operating Income

= $704,000 =1.77

$396,800

2. Flat Rate Lease:

Prepare contribution margin income statement

  

Particulars	Amount ($)
Sales (22,000 units x $80)	17,60,000
Less-Variable cost (22,000 x $40)	8,80,000
Contribution Margin	8,80,000
Less Fixed cost	427,200
Operating Income	452,800

Computing Operating leverage as follows:

Operating leverage = Contribution margin

Operating Income

= $8,80,000 =1.94

$452,800

d)

1. Unit rate lease

Margin of safety = Actual Sales-Break even sales

= (22,000 x $80) - ( 9,600x $80)

=$17,60,000 - $ 7,68,000

= $ 9,92,000

Margin of safety (%) = Margin of safety

Actual Sales

= $9,92,000 x 100 = 56.36%

$17,60,000

2. Flat rate lease

Margin of safety = Actual Sales-Break even sales

= (22,000 x $80) - ( 10,680x $80)

=$17,60,000 - $ 8,54,400

= $ 9,05,600

Margin of safety (%) = Margin of safety

Actual Sales

= $9,05,600 x 100 = 51.45%

$17,60,000

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