Question

The Problem You own and manage a pretzel and lemonade concession cart. You decide that you want to sell your products at a NASCAR® race weekend in Loudon, NH. The track charges $1,000 in rent for the entire weekend. Food and beverage costs run about 20% of sales. You have to pay an employee $400 to run the cart over the weekend. You provide incentives of 5% of sales. Your accountant allows you to take $250 in depreciation expenses for this weekend as well. Let’s pretend you use the cart for only one weekend per year (therefore, this one weekend is your annual sales and expenses). The car costs you $1,250 to purchase and you expect to use it for 5 years (with depreciation of $250 per year). Assume a required rate of return of 15%.

Question 1 – Find Accounting and Cash Flow Breakeven

? If the average lemonade or pretzel sale is $5/each, how many items will you have to sell to reach accounting breakeven?

? How many units do you need to sell cash flow breakeven? (Assume no taxes).

? How many units do you need to sell to reach financial breakeven?

Question 2 – Calculate Degree of Operating Leverage You estimate that your sales for the weekend will either be “average” or “great”:

• Average: 500 units sold

• Great: 750 Units sold Calculate the degree of leverage at AVERAGE and GREAT sales? DOL = 1 + (FC/OCF)

Question 3 – Test your answer! From question 2, increase unit sales 10%. Show that your OCF went up by the degree of operating leverage suggested. Example. Say you calculated a DOL of 2.5. An increase in sales of 10% would suggest OCF would increase 25%. Conclusion Companies with a higher fixed overhead (and hence, lower variable costs relative to fixed costs) must reach a higher level of sales prior to becoming profitable. However, they will enjoy a greater increase in profits as sales increase.

	HIgh Operating Leverage	Low Operating Leverage
Breakeven	Higher	Lower
Increase in Profit	Faster	Slower

Answer 1

QUESTION1

ACCOUNTING BREAKEVEN

the fixed expenses are:

rent                    =$1000

employee salary   $400

depreciation           $250

TOTAL FIXED EXPENSES=$ 1650

variable expenses are

food & beverages (20% 0f sales)

employee incentive (5% of sales)

since variable expenses are 25% of sales, the contribution margin = 75% OR 0.75

accounting breakeven = total fixed costs/ contribution margin ratio= 1650/0.75= $2200

So required sales = $2200 or $2200/$5 =   440 units

CASH BREAKEVEN POINT

cash breakeven= fixed costs other than depreciation/contribution margin (note: depreciation is non cash item)

= 1400/0.75= $1866.66

So required sales =%1866.66 or $1866.66/$5= 373 units

FINANCIAL BREAKEVEN

financial breakeven is that level of sales where project will have zero NPV

OR present value of cash inflows - initial investment =0

Let required sales in units be x.So sales revenue = $5 * x= 5x

food & beverage will be 20% of 5x= x

employee incentivewill be 5% of 5x= 0.25x

total variable cost will be   1.25x

cashflow = sales - variable costs - fixed costs (other than depreciation)

5x-1.25x-1400= 3.75x-1400

we multiply this annual cashflow by present value interest factor for an annuity for 5 yrs at 15%, which is 3.352

3.352(3.75x-1400)= 12.57x-4692.8

initial investment-1250

equating present value of cash inflows with initial investment, we get

12.57x- 4692.8=1250

12.57x= 5942.8

x= 473 units

question2

PARTICULARS	500 UNITS	750 UNITS
sales	$2500	$3750
less variable costs
food 20%	$500	$750
incentive 5%	$125	$187.5
contribution	$1875	$2812.5
less : fixed costs	$1650	$1650
net operating income	$225	$1162.5

operating leverage = contribution/net operating income= 1875/225= 8.33 times