Question

Kramerica Industries decided to compete in the market of "tip calculators" by designing a cheaper version of the Sharp Wizard and offering it for only $50 (as opposed to the $200 genuine Wizard). After successful pilot testing at a resort in Del Boca Vista, Kramerica Industries realized that they needed to significantly boost their production capacity for the upcoming holiday season. Kramerica is deciding whether or not to purchase a new piece of manufacturing equipment to adequately produce the volume in-house, or alternatively lease the equipment from the Voorhees contract manufacturing group. If Kramerica Industries decides to purchase the equipment, then the initial cost of this equipment would be $500,000 with daily variable operating costs of $500 per day. Alternatively, instead of purchasing the equipment, the daily leasing cost paid to Voorhees would be $1,500 per day.

(a) How long will it take for the leasing cost to be the same as the purchasing cost (i.e., the "break-even point" in DAYS)?

(b) If the early projections are for the product to sell for about three years (i.e., 1,095 days), what should Kramerica do (i.e., purchase the manufacturing equipment or lease the equipment from Voorhees)?

(c) Explain the rationale of your decision in (b) in terms of the significance of the "breakeven" date with fixed purchase cost and difference between the variable costs (i.e., does the length of this production project justify the purchase cost even though the variable costs are less?).

(d) How would your recommendation change if the manufacturing equipment was expected to sell for one year (i.e., 365 days)?

Answer 1

a) Breakeven point (BEP):

BEP = Fixed cost / excess variable cost incurred

Fixed cost = 500,000

Lease cost (over and above variable operating cost) = 1500 - 500 = 1,000

(It is assumed that lease cost includes variable operating cost)

BEP = 500,000/ 1,000 = 500 days

Therefore, for less than 500 days, it will be beneficial for the company to lease the equipment and for more than 500 days, it would be economical to purchase the equipment.

b) If the product was to sell for 3 years, it would be better to purchase the manufacturing equipment.

Let's cross check:

Purchase cost = 500,000 + (500 * 1095) = 1,047,500

Leasing cost = 1500 * 1095 = 1,642,500

Hence, purchasing the maufacturing equipment is better.

c) Break-even point helps management to make a decision whether to buy the equipment or to lease it depending upon the period of production.

d) If the equipment was to sell for one year, then it would be better to lease the equipment as the period is less than 500 (break-even point).

Check:

Purchase cost = 500,000 + (500 * 365) = 682,500

Leasing cost = 1500 * 365 = 547,500

Therefore, it is better to lease the equipment.