Question

Help Save & Exit 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 $5 per unit produced, regardless of the number of units. The second lease option (flat-rate lease) is one where Canton would pay $75,000 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 $50 per unit and unit variable cost (excluding any machine lease costs) are $25. Monthly fixed costs (excluding any machine lease costs) are $220,000 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 20,500 units. What is the operating leverage assuming 1. The unit-rate lease? 2. The flat-rate lease? d. Assume monthly volume of 20,500 units. What is the margin of safety percentage assuming 1. The unit-rate lease? 2. The flat-rate lease?

Answer 1

Solution

1. Under the 1st Option (lease @ $ 5 Per Unit) the net contrinution per unit will further reduced by the lease cost PU. Hence the contribution PU

Sales Value reduced by unit variable cost further reduced by unit lease cost =

$ 50 - $ 25 - $ 5 = $ 20 Net contribution

Break Even Formula = Fixed cost divided by contribution

PU = $ 220,000/ $ 20 = 11,000 units to be produced to reach break even

2. Under the 2nd Option (lease $ 75,000 per month).

This will be treated as fixed cost, as this has no relevance with the unit to be produced.

Contribution = Sales Value reduced by unit variable cost

$ 50 - $ 25 = $ 25 Net contribution

Break Even Formula = Fixed cost devided by contribution PU =

(220,000 + $ 75,000)/ $ 25 = 11,800 units to be prodcued to reach break even.

b. While Calculating operating Income, fixed cost has no relevance. However considering the either of lease option we may calculate as per following formula

25 X - 5 X = 25 X -$75,000

Hence 5 X = $ 75,000

Finally X = 15,000

At 15,000 units operating profit will be same reagrdless lease option.

C. 1. The formula Operating Leaverage = Quantity * Contribution margin Divided by (Quantity * Contribution margin - Fixed Operating Cost)

Here the contribution PU = Selling price - Variable cost - Cost PU of lease

= $ 50 - $ 25 - $5 = $ 20

(20,500 Units * $ 20 ) / ((20,500 Units * $ 20) - $ 220,000) = 2.15

c.2

The formula Operating Leaverage = Quantity * Contribution margin Divided by (Quantity * Contribution margin - Fixed Operating Cost)

Here the contribution PU = Selling price - Variable cost = $ 50 - $ 25 = $ 25

However Fixed cost will increased by the lease amount ( $ 220,000 + $ 75,000) = $ 295,000

(20,500 Units * $ 25 ) / ((20,500 Units * $ 25) - $ 295,000) = 2.35

d. 1

Margin of Safety at volume of 20,500 units =  

Formual of Margin of Safety % = Sales Value divided by net contribution against total Sales volume  

The contribution against 20,500 units = ($ 20 * 20,500) minus $ 220,000 = $ 190,000

Sales Value = $ 50 * 20,500 = $ 10,25,000

Margin of Safety % = $ 190,000 / $ 10,25, 000 = 18.53%

d. 2

Margin of Safety at volume of 20,500 units =  

Formual of Margin of Safety % = Sales Value divided by net contribution against total Sales volume  

The cotribution agaisnt 20,500 units = ($ 25 * 20,500) minus $ 295,000 = $ 217,500

Sales Value = $ 50 * 20,500 = $ 10,25, 000

Margin of Safety % = $ 217,500 / $ 10,25,000 = 21.21%