Problem - Cavalier Chairs, Inc., a producer and retailer of custom design office chairs, is considering opening a new retail store.
In negotiating the cost of the space, they were given two rental options:
- Option 1 - A fixed rental price of $1,200 per week; OR
- Option 2 - A rental charge based on total sales. The charge would be 15% of monthly sales revenue plus a fixed monthly payment of $1,000.
For the new retail store, Cavalier Elements estimates that their other costs would be:
- Average cost of store items = $175 per unit
- Store manager's salary = $850 per month
- Sales commissions = 10% of sales revenue
- Other selling, general and administrative expenses = 8% of sales plus a monthly cost of $1,000 per month, (i.e. this amount does not include store rental costs or store manager's salary).
The average selling price of a Cavalier's office chair is $375 each.
a. Assuming the initial month's expected unit sales are 50 chairs, prepare a Contribution Margin Income Statement for Option 1 and a Contribution Margin Income Statement for Option 2,
b. Compute the breakeven in sales units for (a) Option 1 and (b) Option 2.
c. Determine the level of total revenues at which the company will be indifferent between Option 1 and Option 2.
d. Compute the degree of operating leverage at sales of 50 units for (a) Option 1 and (b) Option 2.
e. Given your computation in d., which Option will have the greater increase in income with increases in sales activity? Please explain your answer.
f. Given your computation in d., which Option is the least risky Option if the demand for Cavalier's chairs declines in subsequent period? Please explain your answer.