Question

5. Thad Morgan, a motorcycle enthusiast, has been exploring the possibility of relaunching the Western Hombre brand of cycle that was popular in the 1930s. The retro-look cycle would be sold for $10,000 and at that price, Thad estimates 600 units would be sold each year. The variable cost to produce and sell the cycles would be $7,500 per unit. The annual fixed cost would be $1,200,000.

1. Using your worksheet, what would be the break-even unit sales, the margin of safety in dollars, and the degree of opera ting leverage
2. Thad is worried about the selling price. Rumors are circulating that other retro bands of cycles may be revived. If so, the selling price for the Western Hombre would have to be reduced to $9,000 to compete effectively. In that event, Thad would also reduce fixed expenses by $300,000 by reducing advertising expenses, but he still hopes to sell 600 units per year. Do you think this is a good plan? Explain. Also, explain the degree of operating leverage that appears on your worksheet.

Answer 1

5.a		Total	Per Unit
	Sales(600 units)	$            60,00,000	$                 10,000.00
	Variable expenses	$            45,00,000	$                   7,500.00
	Contribution Margin	$            15,00,000	$                   2,500.00
	Fixed expenses	$            12,00,000
	Net Operating Income	$              3,00,000
	Contribution Margin Ratio($2500/$10,000)	25%
	Break-even Point($1,200,000/$2500)	480	units
	Break-even Point in Dollars($1,200,000/25%)	$            48,00,000
	Margin of safety in dollars($6,000,000-$4,800,000)	$            12,00,000
	Degree of operating leverage($1,500,000 / $300,000)	5 times
5.b		Total	Per Unit
	Sales(600 units)	$            54,00,000	$                   9,000.00
	Variable expenses	$            45,00,000	$                   7,500.00
	Contribution Margin	$              9,00,000	$                   1,500.00
	Fixed expenses	$              9,00,000
	Net Operating Income	$                         -
	Contribution Margin Ratio($1500/$9,000)	16.67%
	Break-even Point($900,000/$1500)	600	units
	Break-even Point in Dollars($900,000/16.67%)	$            54,00,000
	Margin of safety in dollars($5,400,000-$5,400,000)	$                         -
	Degree of operating leverage($1,500,000 / $300,000)	N.A
	No this is not a good plan as the Net Income has decreased by $300,000 and the company is at break-even.
	The degree of operating leverage can not be determined as the company will have to operate at Break even and there is no leverage with the company in this case.