Question 3.4 Conduct a sensitivity analysis and use margin of safety to give Cro

Question

Question 3.4 Conduct a sensitivity analysis and use margin of safety to give Crooked Creek wine advice about two different proposed labour costing methods. Crooked Creek Wines operates a cellar door venue in which customers can sample and purchase wines. The average revenue per day is $750, variable cost per day is $250 and annual fixed costs for the cellar door operations is $95,000. Assume 290 operating days. Calculate the margin of safety in units and dollars and the margin of safety percentage based on the information above. If Crooked Creek Wines considers changing the labour costs for cellar door operations to include a commission for all wine sales of 2.5%, this would reduce the fixed costs to $90,000. Calculate the degree of operating leverage at 290 operating days under the two options – the present cost structure and the commission.

a) Calculate the degree of operating leverage at 290 operating days under the two options – the present cost structure and the commission.

b) Write a short summary of your analysis and include any recommendations to the management of Crooked Creek Wines

Explanation / Answer

1) Break even point in number of days = Fixed cost/Contribution margin per day = 95000/(750-250) = 190 days Margin of safety in units (days) = 290-190= 100 Margin of safety in dollars = 100*750 = $75000 Margin of safety in % = (100/290) = 34.48% a) Degree of Operating Leverage: Present cost structure: Sales = 290*750 = 217500 Variable cost = 290*250 = 72500 Contribution margin 145000 Fixed costs 95000 Net operating income 50000 Degree of operating leverage = Contribution margin/Net operating income = 145000/50000 = 2.90 With sales commission: Sales = 290*750 = 217500 Variable cost = 290*250 = 72500 Sales commission at 2.5% of sales 5438 Contribution margin 139563 Fixed costs 90000 Net operating income 49563 Degree of operating leverage = Contribution margin/Net operating income = 139563/49563 = 2.82 b) The payment of commission will reduce NOI by $437. The DOL, however decreases to 2.82 signifying lower risk. Break even point will be = 90000/(750-250-750*2.5%) = 187 days BEP also signifies lower risk. If the expected number of operating days is more than 190, it would be advisable to stick to the existing cost structure as it will bring more contribution margin per day.

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