The Problem You own and manage a pretzel and lemonade concession cart. You decid

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 racetrack owners let you choose one of the following rental “options”:

Low “Overhead” Rent - “Commission” of 30% of total sales

High “Overhead” Rent - $1,000 fixed rental cost for the entire weekend

Your food and beverage costs are 20% of total sales. You also have to pay an employee $400 to run the cart over the weekend.

Question 1 – Find Breakeven

For each scenario, calculate at what level of sales where you will reach the breakeven point.

Question 2 – Calculate Degree of Operating Leverage

You estimate that your sales for the weekend will either be “average” or “great”:

Average: $2,800 in sales

Great: 50% higher than “average” or $4,200

What is your degree of leverage at AVERAGE sales of $2,800 for both the low and high overhead scenario?

Operating Leverage =         Sales – Total Variable Cost         

                                    Sales – Total Cost (Fixed and Variable)

Question 3 – Calculate Profits and Increase In Profitability

Calculate the profit potential for an average and great weekend for both the low overhead scenario and the high overhead scenario.

How much did profits increase by relative to an increase in sales for both scenarios?

How does this compare with the answers you derived in question 2?

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 Profits

Faster

Slower

High Operating Leverage

Low Operating Leverage

Breakeven

Higher

Lower

Increase In Profits

Faster

Slower

Explanation / Answer

Q1

In Low overhead

Variable costs are 50% (30% commission+20% food and beverage cost)

Fixed cost is $400 (employee cost)

To achieve break even you should atleast achieve sales such that

Sales = Total cost = Fixed + Variable cost

Sales –Variable cost = fixed cost

Sales – 50% Sales = $ 400

50% sales = $ 400

Sales = $ 800

High overhead

Variable costs are 20% (20% food and beverage cost)

Fixed cost is $1,400 (employee cost+Rent cost))

To achieve break even you should atleast achieve sales such that

Sales = Total cost = Fixed + Variable cost

Sales –Variable cost = fixed cost

Sales – 20% Sales = $ 1,400

80% sales = $ 1,400

Sales = $ 1,750

Q2

Operating leverage = (Sales – Variable Costs)/(Sales – Total Costs)

Low Overhead

Operating leverage = (Sales – Variable Costs)/(Sales – Total Costs)

Operating leverage = (2,800-50%*2,800)/(2800-50%(2,800)-400) = 1.40

High Overhead

Operating leverage = (2,800-20%*2,800)/(2800-20%*2,800-1400) = 2.67

Q3

Sales of $ 2,800

Lower Overhead Profit = Sales – Fixed Cost – Vairable costs = 2,800-400-50%*2,800 = 1,000

High Overhead = Sales – Fixed Cost – Vairable costs = 2,800-1400-20%*2,800 = 840

Sales of $ 4,200

Lower Overhead Profit = Sales – Fixed Cost – Vairable costs = 4,200-400-50%*4,200 = 1,700

High Overhead = Sales – Fixed Cost – Vairable costs = 4,200-1400-20%*4,200 = 1,960

Increase in Profit in Lower overhead = (1700-1000)/1000 = 70%

Increase in Profit in Highrt overhead = (1960-840)/840 = 133.33%

Conclusion – Part of Question

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