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 700 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 $1,312,500.

a. What is the break-even in unit sales?

b. What is the margin of safety in dollars?

c. What is the degree of operating leverage? (Round your answer to 2 decimal places.)

Thad is worried about the selling price. Rumors are circulating that other retro brands of cycles may be revived. If so, the selling price for the Western Hombre would have to be reduced to $8,500 to compete effectively. In that event, Thad would also reduce fixed expenses to $1,011,500 by reducing advertising expenses, but he still hopes to sell 700 units per year.

d. What would the net operating income be in this situation? (Negative amount should be indicated by a minus sign.)

Answer 1

a)	BEP(units)
	fixed cost/contribution margin per unit
	1,312,500 / (10,000 - 7,500)
	525 units
b)	Margin of safety
	actual sales - BEP sales
	(700 - 525)*10,000
	1,750,000
c)	Degree of operating leverage
	contribution / net income
	(2,500 * 700) / (2,500 * 700 - 1,312,500)
	1,750,000 / 437,500
	4
d)	net operating income
	contribution margin (8,500 - 7,500) * 700	700,000
	less fixed expense	1,011,500
	net operating (loss)	(311,500)