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Exercise 21-21 1. Prepare a contribution margin income statement for Co. A to compute its DOL 2. Prepare a contribution margin income statement for Co. B to compute its DOL 3. Analyze and interpret which company benefits more from a 20 sales increase. Step 1. Company AContribution Margin Income StatementSales (given) 6,000,000Variable costs 6,000,000 x (100 - 60) 2,400,000Contribution margin (6,000,000 x 60) 3,600,000Fixed costs (given) 2,600,000Pretax income 1,000,000 Company As DOLContribution margin in dollars / Pretax income3,600,000 / 1,000,0003.6Step 2. Company BContribution Margin Income StatementSales (given) 4,500,000Variable costs 4,500,000 x (100 - 25) 3,375,000Contribution margin (4,500,000 x 25) 1,125,000Fixed costs (given) 375,000Pretax income 750,000 Company Bs DOLContribution margin in dollars / Pretax income1,125,000 / 750,0001.5 Step 3. Interpretation Company A benefits more from a 20 increase in sales. This is because we expect a 20 increase in sales to yield a 72 increase in income (computed as 3.6 x 20). For Company B we expect a 20 increase in sales to yield a 30 increase in income (computed as 1.5 x 20). Note that although Company As fixed costs are higher, its increase in income is greater than that for Company B due to its higher degree of operating leverage (3.6 versus 1.5). Problem 21-4A (75 minutes) Part 1 Instructor note Use the equation in Exhibit 21.12 2013 break-even in sales dollars Fixed costs / Contribution margin ratio 250,000 / 20 1,250,000 To compute contribution margin ratio Sales price per unit (1,000,000 / 20,000) 50Variable costs per unit (800,000 / 20,000) 40Contribution margin ratio (50- 40) / 50) 20 Part 2 Instructor note Use the equation in Exhibit 21.12 with predicted numbers 2014 break-even in sales dollars Fixed costs / Contribution margin ratio 450,000 / 60 750,000 To compute predicted fixed costs 2013 fixed costs plus 2014 increase (250,000 200,000) 450,000 To compute predicted contribution margin ratio Predicted sales price per unit (no change in sales price) 50Predicted variable costs per unit (40 x 50) 20Predicted contribution margin ratio (50- 20) / 50) 60 Part 3 ASTRO COMPANYForecasted Contribution Margin Income Statement For Year Ended December 31, 2014Sales (20,000 x 50) 1,000,000Variable costs (20,000 x 20) 400,000Contribution margin (20,000 x 30) 600,000Fixed costs 450,000Net income 150,000 Problem 21-4A (Continued) Part 4 Instructor note Use equations in Exhibits 21.22 and 21.23 with predicted numbers (Fixed costs Target pretax income) Required sales in dollars Contribution margin ratio (450,000 200,000) / 60 650,000 / 60.0 1,083,333 (rounded to whole dollars) (Fixed costs Target pretax income) Required sales in units Contribution margin per unit (450,000 200,000) / (50 - 20) 650,000 / 30 21,667 units (rounded to whole units) Alternately Required sales in units 1,083,333 / 50 Sales price per unit 21,667 units (rounded to whole units) 2013 fixed costs plus 2014 increase (250,000 200,000) 450,000 Target after-tax income (given) 140,000 Pretax target income After-tax target income / (1 Tax rate) 140,000 / (1 0.30) 200,000 Predicted contribution margin ratio (50- 30) / 50)from part 2 60 Taken from required sales in dollars abovePart 5 ASTRO COMPANYForecasted Contribution Margin Income Statement For Year Ended December 31, 2014Sales (21,667 units x 50) 1,083,350Variable costs (21,667 units x 20) 433,340Contribution margin (21,667 units x 30) 650,010Fixed costs (from part 2) 450,000Income before income taxes 200,010Income taxes (200,010 x 30) 60,003Net income 140,007 Slightly greater than the targeted 140,000 income due to rounding of units. Problem 21-5A (65 minutes) Part 1 Instructor note Use the equation in Exhibit 21.12 Break-even in dollar sales Fixed costs / Contribution margin ratio Product T 125,000 / 20 625,000 Product O 1,475,000 / 87.5 1,685,714 (rounded to the nearest dollar) To compute contribution margin ratio Sales price per unit Product T (2,000,000 / 50,000) Product O (2,000,000 / 50,000) __T__ 40__O__ 40Variable costs per unit Product T (1,600,000 / 50,000) Product O (250,000 / 50,000) 32 5Contribution margin ratio Product T (40- 32) / 40) Product O (40- 5) / 40) 20.0 87.5 Part 2 Forecasted contribution margin income statements for each product assuming sales declines to 30,000 units with no change in unit sales price VANNA Co.Forecasted Contribution Margin Income StatementProduct TProduct OSales 1,200,0001,200,000Variable costs 960,000 150,000Contribution margin 240,0001,050,000Fixed costs 125,000 1,475,000Income before taxes 115,000(425,000)Income taxes (32) 36,800 (136,000)Net income 78,200 (289,000) Unit sales price and variable costs are computed in Part 1 and used in these computations Product T sales 30,000 units x 40 Product O sales 30,000 units x 40. Product T variable costs 30,000 units x 32 Product O variable costs 30,000 units x 5. Problem 21-5A (Continued) Part 3 Forecasted contribution margin income statements for each product assuming sales increase to 60,000 units with no change in unit sales price VANNA Co.Forecasted Contribution Margin Income StatementProduct TProduct OSales 2,400,0002,400,000Variable costs 1,920,000 300,000Contribution margin 480,0002,100,000Fixed costs 125,000 1,475,000Income before taxes 355,000625,000Income taxes (32) 113,600 200,000Net income 241,400 425,000 Unit sales price and variable costs are computed in Part 1 and used in these computations Product T sales 60,000 units x 40 Product O sales 60,000 units x 40. Product T variable costs 60,000 units x 32 Product O variable costs 60,000 units x 5. Part 4 If sales were to greatly decrease, Product O would suffer the greater loss because it would lose more contribution margin per unit than Product T (35 for O versus 8 for T). Examining the operating leverage of these two products can yield the same inference. Specifically, higher operating leverage reflects higher fixed costs, which implies greater impacts on income from changes in sales levels. In the extreme, at zero sales, Product O would have a loss equal to its fixed costs of 1,475,000, while Product Ts loss would be only 125,000. Part 5 Factors that could cause Product T to have lower fixed costs might include Labor arrangement that pays workers for units produced. Sales representatives that work totally on commission. Managers that are compensated with a share of profits instead of salaries. Assets that are used in production of Product T are leased with the rent based on asset usage. In contrast, fixed costs for Product O may be higher because of A salary structure that is not based on production or sales. Product Os assets that are owned or obtained under a lease agreement based on time, and not on asset usage. 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Operating Leverage

Operating Leverage

Question # 00050580 Posted By: aazevedo Updated on: 02/24/2015 07:19 PM Due on: 02/26/2015
Subject Accounting Topic Accounting Tutorials:
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Operating leverage refers to the extent to which a company uses fixed costs in its cost structure. If a company has a relatively high proportion of fixed costs relative to its variable costs, then it has the potential for generating large percentage increase in net income from a relatively small increase in sales revenue.

1. In your words, describe operating leverage and how it might be useful to you.

2 How would you describe the operating leverage of your current or previous employer? If you do not have work experience to draw upon, then answer this question in terms of a particular industry, e.g., banking, manufacturing, health-care, education, government, etc.

3. If you were to go into your own business, what mix of fixed and variable costs do you think you would prefer? Why?


Exercise

Company A is a manufacturer with current sales of $6,000,000 and a 60% contribution margin. Its fixed costs equal $2,600,000. Company B is a consulting firm with current service revenues of $4,500,000 and a 25% contribution margin. Its fixed costs equal $375,000. Compute the degree of operating leverage (DOL) for each company. Identify which company benefits more from a 20% increase in sales and explain why.


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