Question

A McDonald’s franchise sells many fast-food items including hamburgers, French fries, drinks, etc. It had fixed costs of $500,000 last year. It had a short-run total variable cost of $726,000, average price of $8, and sold 300,000 food items last year. Raising Cane’s specializes in chicken meals; hence has a limited menu. Last year, it had fixed costs of $200,000 per year, a short-run total variable cost of $199,800, sold 90,000 food items at an average price of $7.00 per item.

i. What is the breakeven output of each firm?

ii. How many more units of output should each firm produce to generate a total profit of $20,000?

iii. Which firm has the higher degree-of-operating leverage (DOL)?

iii. What does it mean to have the higher the DOL?

Answer 1

1.

Average VC per unit for McDonald = 726000/300000 = $2.42

Breakeven point for McDonald = 500000/(8 - 2.42) = 89605.73 or 89606 units

Average VC per unit for Raising Cane = 199800/90000 = $2.22

Breakeven point for Raising Cane =200000/(7-2.22) = 41841 units

2.

To earn profit of $20000

More units to be produced by McDonald = 20000/(8 - 2.42) = 3584.23 or 3584 units

More units to be produced by Raising Cane = 20000/(7-2.22) = 4184.1 or 4184 units

3.

DOL for McDonald = (8*300000 - 726000)/(8*300000 - 726000-500000)

DOL for McDonald = 1.43

DOL for Raising Cane = (7*90000 - 199800)/(7*90000 - 199800 - 200000)

DOL for Raising Cane = 1.87

So, Raising Cane has higher DOL

4.

Higher DOL means firm is more leveraging of the available resources such as machines, equipment and existing setup.