Rachel sells custom-ordered, fabric headbands over the internet for $20 each. The fabric and elastic used to make the headbands will cost $4 per headband. Rachel has contracted with a local seamstress to make the headbands using the seamstress's own equipment, at a price of $8 per headband. Rachel has also hired an internet marketing firm to maintain the website and banner ads on search engines and other websites. This firm charges Rachel $1,200 per month plus 25% of sales revenue. Rachel also spends $300 per month traveling to different fabric suppliers to research possible new fabrics. (Rachel'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 Rachel two contract options to retain their services for the coming year. She can either pay them 1) $1,200 per month plus 25% of revenue, or, 2) $2,400 per month plus 15% 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 Rachel be indifferent between the two contract options?
3. If Rachel expects to sell 1,000 headbands per month during the coming year, which contract term should she choose (which would be the most profitable for her)?