Answer: a) 2.27
b) 22.73% reduction
c) 2.5
Explanation:
a) Operating leverage is calculated by the following formula,
= Contribution Margin / Net Operating Income.
Contribution Margin is Sales - Variable costs which is,
= (90 - 80) * 50,000 units.
= $500,000
Net Income is,
= Sales - Variable Costs - Fixed assets.
We already have Sales - Variable costs so net income would be,
= 500,000 - 280,000
= $220,000
Calculating Operating Leverage we have
= 500,000/220,000
= 2.27
b) Sales Decrease by 10%
= 50,000 units ( 1 - 10%)
= 45,000 units.
Net Income would thus become,
= (90*45,000) - (80*45,000) - 280,000
= 4,050,000 - 3,600,000 - 280,000
= 170,000
Percentage change is,
= (220,000 - 170,000) / 220,000 * 100%
= 22.73%
c) Variable costs become $77.50 and fixed assets become $375,000.
New calculation of Operating Leverage will become,
Contribution Margin = Sales - Variable cost
= (90 - 77.50) * 50,000 units
= $625,000
Net Income is,
= 625,000 - 375,000
= $250,000
Operating Leverage = 625,000/250,000
= 2.5
The Operating Leverage increased. This is because the Contribution Margin rose as a result of fixed costs being less. Fixed costs rose as well but at a lesser rate than the drop in the Variable costs which ultimately meant that the numerator (Contribution Margin) rose more than the denominator ( net income).
