8. A new company to produce state-of-the-art car stereo systems is being conside
ID: 2804313 • Letter: 8
Question
8. A new company to produce state-of-the-art car stereo systems is being considered by Jagger Enterprises. The sales price would be set at 1.5 times the variable cost per unit; the VC/unit is estimated to be $2.50. What sales volume would be required in order to break even, i.e., to have an EBIT of zero for the stereo business with the following assumptions of fixed costs? A) Fixed costs are estimated at $120,000 vs. fixed costs are estimated at $100,000. B) What do the above results suggest with regard to the operating leverage vs. business risk?Explanation / Answer
a. Break even point = Fixed Costs / (Price - Variable cost)
Fixed costs = 120,000; variable cots = 2.50 and price = 1.5*2.50 = 3.75
Break even point at fixed cost of 120,000 = 120,000/(3.75-2.50) = 96,000 units
Break even point at fixed cost of 100,000 = 100,000/(3.75-2.50) = 80,000 units
b. The above result show us that when the fixed cost is reduced, the break-even point also reduces by the same extent. So it is better for the business to take on additional operating leverage and reduce fixed cost thereby increasing business risk which will improve profitability. When additional leverage is taken, the interest also gets a tax advantage.
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