Cortez Enterprises is studying the addition of a new product that would have an
ID: 2394767 • Letter: C
Question
Cortez Enterprises is studying the addition of a new product that would have an expected selling price of $180 and expected variable cost of $120. Anticipated demand is 9,000 units.
A new salesperson must be hired because the company's current sales force is working at capacity. Two compensation plans are under consideration:
Plan 1: An annual salary of $38,000 plus 10% commission based on gross sales dollars
Plan 2: An annual salary of $180,000 and no commission
Required:
What is meant by the term "operating leverage"?
Calculate the contribution margin and net income of the two plans at 9,000 units.
Compute the operating leverage factor of the two plans at 9,000 units. Which of the two plans is more highly leveraged? Why?
Assume that a general economic downturn occurred during year no. 2, with product demand falling from 9,000 to 7,200 units. By using the operating leverage factors, determine and show which plan would produce a larger percentage decrease in net income
PLEASE SHOW ALL YOUR WORK
Explanation / Answer
OPERATING LEVERAGE EXISTS WHEN A FIRM HAS A FIXED COST THAT MUST BE DEFRAYED REGARDLESS OF VOLUME OF BUSINESS .IT CAN BE DEFINED AS THE FIRM'S ABILITY TO USE FIXED OPERATING COSTS TO MAGNIFY THE EFFECT OF CHANGES IN SALES ON ITS EARNINGS BEFORE INTEREST AND TAXES .DEGREE OF OPERATING LEVERAGE IS EQUAL TO THE PERCENTAGE INCREASE IN THE NET OPERATING INCOME TO THE PERCENTAGE INCREASE IN OUTPUT.
SALE
LESS VARIABLE COST
[9000*180] 1620000
[9000*120] 1080000
[9000*180] 1620000
[9000*120] 1080000
CALCULATION OF SALARY IN PLAN 1:-
38000+10%OF 1620000
=38000+162000
=200000.
OPERATING LEVERAGE FACTOR
OPERATING LEVERAGE FACTOR= CONTIBUTION PLAN 1 PLAN 2 NET INCOME
= 540000 540000 340000 360000
1.59 1.5
DURING YEAR 2 PLAN 1 PLAN 2
SALES 7200*180 1296000 7200*180 1296000
LESS VARIABLE COST 7200*120 864000 7200*120 864000
CONTRIBUTION 432000 432000
NET INCOME =CONTRIBUTION 432000 271700 432000 288000 LEVERAGE FACTOR 1.59 1.50
PLAN 1 PLAN 2SALE
LESS VARIABLE COST
[9000*180] 1620000
[9000*120] 1080000
[9000*180] 1620000
[9000*120] 1080000
CONTRIBUTION MARGIN 540000 540000 LESS SALARIES 200000 180000 NET INCOME 340000 360000