Prestige manufactures a line of female cosmetics, including lipsticks, face creams, eyeliners, and so forth. Prestige manufactures its own products to maintain proprietary information and to assure high-quality standards. They have just developed a new exfoliating masque face cream in a unique tube and applicator that they expect to sell for $12.00 per unit. To manufacture the new face cream, Prestige will have to lease new equipment. Only two companies manufacture the necessary equipment for producing the face cream, a German company and a Swedish company. The following table lists the two alternative production technologies that Prestige can use to produce the new face cream.
Technology ___________________ German _______________ Swedish
Fixed cost (annual) .................... $500,000 ...................... $900,000
Variable cost/unit ......................... $8.00 ............................. $6.00
Maximum annual capacity (units) .... 215,000 ....................... 380,000
The German equipment has an annual capacity of 215,000 units per year, whereas the Swedish equipment can produce up to 380,000 units per year. Both companies require Prestige Products to sign a five-year, non-cancelable lease for the annual lease payment ($500,000 for the German equipment and $900,000 for the Swedish equipment). The variable costs include the labor and material ($8 if the German equipment is used and $6 if the Swedish equipment is used).
Required:
a. Calculate the break-even point if Prestige were to lease the German equipment.
b. Calculate the break-even point if Prestige were to lease the Swedish equipment.
c. Which equipment (German or Swedish) should Prestige lease (and why)?
d. Suppose that Prestige management expects to sell 180,000 masques per year. Calculate the average cost (fixed plus variable cost) of the German and Swedish equipment at 180,000 units.
e. What is operating leverage and what is the relation between operating leverage and firm value?