You are an economist for the Frito-Lay Corporation, which produces and distributes outdoor cooking supplies. The company has come under new ownership and management and will be undergoing changes in its product lines and operating structure. As an economist, your responsibilities include examining the market factors that affect success or failure of a product, including the supply and demand for the product, market conditions, and the behavior of competitors with similar products.
The new owners are evaluating the operating structure, and you have two possible alternatives. One alternative requires a high level of investment in fixed costs compared to the other alternative. Jorge, your supervisor, has assigned you the task of evaluating the two alternatives.
Assume that the company has no debt. Regardless of the alternative selected, market conditions will require the selling price of the product to be $3.45 per unit. The details for each alternative are given in the table.
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Alternative 1
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Alternative 2
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Variable costs
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$2.20
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$2.70
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Fixed costs
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$80,000
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$30,000
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Total assets
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$350,000
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$350,000
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Jorge has asked you to provide detailed responses to the following questions:
- How does CVP analysis help management in the planning stage of a new business? How does CVP analysis assist the decision makers of an existing business?
- What is the break-even quantity for each of the investment alternatives, calculated using an algebraic approach? Complete the tables for each alternative using the Microsoft Excel Template given below and indicate the break-even points. Using Microsoft Excel, graph the relevant data, showing the break-even points and the profit levels for each alternative. Explain the differences between the two alternatives.
- What is the degree of operating leverage for each alternative at 90,000 units?
- What is the significance of different DOLs using this example?
- What does the return on equity (ROE) ratio tell management? How is it used in the decision-making process?
- What is the ROE under each alternative at an output level of 124,000 for Alternative 1 and 60,000 for Alternative 2? (As the company has no debt, the formula for ROE becomes profit/assets. Use this formula.) Explain the reason for and significance of your answers.
- Which alternative would you recommend to the company? Explain the pros and cons of each alternative and the reasons for your selection.