Following is financial information relative to two companies in the same industr
ID: 2757796 • Letter: F
Question
Following is financial information relative to two companies in the same industry. Alpha Omega Sales $10,000,000 $10,000,000 Variable Cost 5,000,000 2,000,000 Contribution Margin 5,000,000 8,000,000 Fixed Costs 3,000,000 6,000,000 Operating Income $2,000,000 $2,000,000 Required: 1. Calculate the operating leverage for each firm. 2. If sales increased 10% for each firm and the variable cost per unit did not change and the fixed costs did not change, what would be the change in operating income? 3. If sales decreased 20% for each firm and the variable cost per unit did not change and the fixed costs did not change, what would be the change in operating income? 4. Discuss the nuances of operating leverage and its relation to risk.
Explanation / Answer
Answer:
Operating Leverage = Contribution / EBIT or (Sales - Variable Cost) / (Sales - Variable Cost - Fixed Cost)
4. Operating Leverage is the measure of percentage change in Operating Income for every change in Sales figure for a firm which have fixed operating costs. The more the operating leverage the more will be the effect of change in sales on the operating income of the firm. This is evident from the above calculations.
Particulars Alpha Omega Sales 10,000,000 10,000,000 Variable Cost 5,000,000 2,000,000 Contribution (Sales - Variable Cost) 5,000,000 8,000,000 Fixed Cost 3,000,000 6,000,000 Operating Income or EBIT(Contribution - Fixed Cost) 2,000,000 2,000,000 Operating Leverage 2.50 times 4.00 times 2. If Sales increased by 10% then Operating Income will be as under; Sales 11,000,000 11,000,000 Variable Cost 5,500,000 2,200,000 Contribution 5,500,000 8,800,000 Operating Income 2,500,000 2,800,000 3. If Sales is decreased by 20% then Operating Income shall be as under; Sales 8,000,000 8,000,000 Variable Cost 4,000,000 1,600,000 Contribution 4,000,000 6,400,000 Operating Income 1,000,000 400,000