Hannah sells custom-ordered, fabric headbands over the internet for $10 each. The fabric and elastic used to make the headbands will cost $1 per headband. Hannah has contracted with a local seamstress to make the headbands using the seamstress's own equipment at a price of $3 per headband. Hannah has also hired an internet marketing firm to maintain the website and place banner ads on search engines and other websites. This firm charges Hannah $1,000 per month plus 20% of sales revenue. Hannah also spends $500 per month traveling to different fabric suppliers to research possible new fabrics. (Hannah's costs are expected to remain as stated, unless she sells more than 4,000 headbands per month.) The internet firm that will be maintaining her website has offered Hannah two contract options to retain their services for the coming year. She can either pay them 1) $1,000 per month plus 20% of revenue, or 2) $2,000 per month plus 10% of revenue.
Requirements
1. Which alternative will provide her with a lower operating leverage? Briefly explain why.
2. At what level of sales (in units) will Hannah be indifferent between the two contract options?
3. If Hannah expects to sell 1,500 headbands per month during the coming year, which contract term should she choose (which would be the most profitable for her)?