Upscale Hides sells its only product, a leather coat for $3,000 each. The produc
ID: 2651603 • Letter: U
Question
Upscale Hides sells its only product, a leather coat for $3,000 each. The production process is highly labor intensive with almost the entire coat being hand cut and stitched by a single craftsmen. Currently the company's very skilled craftsmen are paid on a finished coat basis. Current variable costs (including labor) per coat are $1,200 and total fixed operating costs for the company are $4,000,000. Fixed interest charges are $500,000.
Upscale is contemplating a change in how it pays its craftsmen. If they are each paid a guaranteed fixed annual salary, total fixed operating costs will rise to $6,400,000 but variable costs per coat will drop to only $400 a coat.
{a} Compute the degree of operating leverage at a sales level of $9,000,000 under both the present pay system and the proposed new one.
{b} Explain why there is a difference between your two values in {a}.
{c} How does the forecasted volatility of future years' sales impact Upscale's decision?
Explanation / Answer
{a} Compute the degree of operating leverage at a sales level of $9,000,000 under both the present pay system and the proposed new one.
Solution:
Sales: $9,000,000
P: $3,000
Q = Sales / P
Q = $9,000,000 / $3,000
Q = 3,000 Coat
OLPresent System = 3,000 ($3,000 - $1,200) / 3,000 ($3,000 - $1,200) - $4,000,000
OLPresent System = $5,400,000 / $5,400,000 - $4,000,000
OLPresent System = 3.85
OLProposed System = 3,000 ($3,000 - $400) / 3,000 ($3,000 - $400) - $6,400,000
OLProposed System = $7,800,000 / $7,800,000 - $6,400,000
OLProposed System = 5.58
{b} Explain why there is a difference between your two values in {a}.
Solution-
The difference between the Operating leverage Present system value and operating leverage Proposed system value because of the change in Fixed cost.
{c} How does the forecasted volatility of future years' sales impact Upscale's decision?
Solution-
The sales will grow in near future if the Upscale's use the variable costs for making the coat.
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