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Problem 7 39

This document summarizes and compares two plans (Plan A and Plan B) for a company considering how to structure its costs. It finds that Plan B has a higher degree of operating leverage because it has a larger percentage of fixed costs compared to sales and a lower percentage of variable costs. As a result, Plan B would experience a larger percentage decrease in profits if sales declined from 6,000 to 5,000 units, showcasing how operating leverage increases sensitivity to sales changes. The document thus recommends that heavily automated companies with high fixed costs are riskier investments during economic downturns due to their high operating leverage.

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145 views3 pages

Problem 7 39

This document summarizes and compares two plans (Plan A and Plan B) for a company considering how to structure its costs. It finds that Plan B has a higher degree of operating leverage because it has a larger percentage of fixed costs compared to sales and a lower percentage of variable costs. As a result, Plan B would experience a larger percentage decrease in profits if sales declined from 6,000 to 5,000 units, showcasing how operating leverage increases sensitivity to sales changes. The document thus recommends that heavily automated companies with high fixed costs are riskier investments during economic downturns due to their high operating leverage.

Uploaded by

ninjai_thelittleninja
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Book.comPROBLEM 7-39 (35 MINUTES) 1.

Plan A break-even point = fixed costs unit contribution margin = $34,100 $31* = 1,100 units Plan B break-even point = fixed costs unit contribution margin = $72,000 $40** = 1,800 units * $90 - [($90 x 10%) + $50] ** $90 - $50

2.

Operating leverage refers to the use of fixed costs in an organizations overall cost structure. An organization that has a relatively high proportion of fixed costs and low proportion of variable costs has a high degree of operating leverage.

PROBLEM 7-39 (CONTINUED) 3. Calculation of contribution margin and profit at 6,000 units of sales:

Plan A Sales revenue: 6,000 units x $90. Less variable costs: Cost of purchasing product: 6,000 units x $50. Sales commissions: $540,000 x 10%... Total variable cost.. Contribution margin Fixed costs. Net income. $540,000

Plan B $540,000

$300,000 54,000 $354,000 $186,000 34,100 $151,900

$300,000 ----__ $300,000 $240,000 72,000 $168,000

Plan A has a higher percentage of variable costs to sales (72.5%) compared to Plan B (62.5%). Plan Bs fixed costs are 13.75% of sales, compared to Plan As 4.58%. Operating leverage factor = contribution margin net income Plan A: $186,000 $151,900 = 1.22 Plan B: $240,000 $168,000 = 1.43 (rounded) Plan B has the higher degree of operating leverage. 4 & 5. Calculation of profit at 5,000 units: Plan A Sales revenue: 5,000 units x $90. Less variable costs: Cost of purchasing product: 5,000 units x $50.. Sales commissions: $450,000 x 10%... Total variable cost.. Contribution margin Fixed costs Net income. $450,000 Plan B $450,000

$250,000 45,000 $295,000 $155,000 34,100 $120,900

$250,000 ---- __ $250,000 $200,000 72,000 $128,000

PROBLEM 7-39 (CONTINUED) Plan A profitability decrease: $151,900 - $120,900 = $31,000; $31,000 $151,900 = 20% Plan B profitability decrease: $168,000 - $128,000 = $40,000; $40,000 $168,000 = 23.8% (rounded) Consolidated Industries would experience a larger percentage decrease in income if it adopts Plan B. This situation arises because Plan B has a higher degree of operating leverage. Stated differently, Plan Bs cost structure produces a greater percentage decline in profitability from the drop-off in sales revenue. Note: The percentage decreases in profitability can be computed by multiplying the percentage decrease in sales revenue by the operating leverage factor. Sales dropped from 6,000 units to 5,000 units, or 16.67%. Thus: Plan A: 16.67% x 1.22 = 20.3% Plan B: 16.67% x 1.43 = 23.8% (rounded) 6. Heavily automated manufacturers have sizable investments in plant and equipment, along with a high percentage of fixed costs in their cost structures. As a result, there is a high degree of operating leverage. In a severe economic downturn, these firms typically suffer a significant decrease in profitability. Such firms would be a more risky investment when compared with firms that have a low degree of operating leverage. Of course, when times are good, increases in sales would tend to have a very favorable effect on earnings in a company with high operating leverage.

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