Financial Analysis: Cover Rugs Sales & Rental Options

Today, we will analyze the financial decisions of Cover Rugs, a company conducting a two-week carpet sale at Josh's Club, a local warehouse store. Cover Rugs plans to sell carpets for $950 each, purchased from a local distributor for $760 each, with the option to return unsold units. Josh's Club has provided two payment alternatives for the use of space: Option 1, a fixed payment of $7,410, and Option 2, 10% of total revenues earned during the sale period. In this report, we will calculate the breakeven point in units for both options, determine the revenue level at which Cover Rugs would earn the same operating income under either option, analyze the preference for each option within different unit sales ranges, and calculate the degree of operating leverage at a sales level of 65 units for both rental options.

Requirement 1: Breakeven Point in Units

To calculate the breakeven point in units for Option 1 and Option 2, we will use the following formula:

For Option 1, the breakeven point is 39 units, while for Option 2, the breakeven point is 0 units.

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This implies that Cover Rugs needs to sell at least 39 units to cover the fixed cost under Option 1, while under Option 2, there is no breakeven point as the costs are variable based on revenue.

Requirement 2: Equal Operating Income

a. To find the range of unit sales where Cover Rugs prefers Option 1, we need to determine when Option 1's operating income is greater than Option 2's.

We will set the two operating incomes equal to each other and solve for the quantity of units sold:

Cover Rugs would prefer Option 1 when the level of revenues is less than or equal to $74,100.

b. To find the range of unit sales where Cover Rugs prefers Option 2, we need to determine when Option 2's operating income is greater than Option 1's. We will set the two operating incomes equal to each other and solve for the quantity of units sold:

Cover Rugs would prefer Option 2 when the level of revenues is greater than $74,100.

Requirement 3: Degree of Operating Leverage

The degree of operating leverage measures the sensitivity of operating income to changes in sales. To calculate it, we use the following formula:

When sales are 65 units, the degree of operating leverage for Option 1 is 2.50, indicating that a percentage change in sales and contribution margins will result in 2.50 times that percentage change in operating income. On the other hand, for Option 2, the degree of operating leverage is 1.00, meaning that a percentage change in sales and contribution margins will have an equal effect on operating income.

Requirement 4: Explanation and Interpretation

The results indicate that Option 1 has a higher degree of operating leverage (2.50) compared to Option 2 (1.00) when sales are at 65 units. This means that Option 1's operating income is more sensitive to changes in sales and contribution margins than Option 2. In practical terms, if Cover Rugs expects sales to fluctuate, Option 1 can lead to more significant variations in operating income, both positive and negative, compared to Option 2. On the other hand, Option 2 provides a more stable operating income since it has a lower degree of operating leverage, which can be advantageous in uncertain market conditions.

In conclusion, the choice between Option 1 and Option 2 depends on various factors, including sales expectations, risk tolerance, and market conditions. Cover Rugs should carefully consider its sales forecasts and financial goals when making the decision between the two rental options.