Question

A proposed project has fixed costs of $43,000 per year. The operating cash flow at 8,000 units is $78,000.

Required:

(a) Ignoring the effect of taxes, what is the degree of operating leverage?

(b) If units sold rise from 8,000 to 8,500, what will be the increase in operating cash flow?

(c) What is the new degree of operating leverage?

Answer 1

a. The degree of operating cash flow can be computed by using the below formula:

= contribution margin / operating income

contribution margin = operating income + Fixed cost

= $ 78,000 + $ 43,000

= $ 121,000

Operating Income = $ 78,000

So our degree of operating leverage would be

= $ 121,000 / $ 78,000

= 1.55 Approximately.

b. If units sold rise from 8,000 to 8,500 the new operating cash flow would be computed as follows:

First of all we shall compute the contribution per unit when we were selling 8,000 units as follows:

Operating cash flow = sales - variable cost - fixed cost

$ 78,000 = sales - variable cost - $ 43,000

$ 121,000 = sales - variable cost (Which is also known as contribution margin)

So our contribution margin is $ 121,000 and contribution margin per unit comes out to be

= $ 121,000 / 8000

= $ 15.125 per unit

So contribution margin for 8,500 units would be

= $ 15.125 x 8,500

= $ 128,562.5

To get the operating cash flow for 8,500 units we need to deduct the fixed cost of $ 43,000

= $ 128,562.50 - $ 43,000

= $ 85,562.50

Increase in operating cash flow

= $ 85,562.50 - $ 78,000

= $ 7,562.5

c. New degree of operating leverage

= contribution margin / operating income

contribution margin = operating income + Fixed cost

= $ 85,562.5 + $ 43,000

= $ 128,562.5

operating income = $ 85,562.5

So our degree of operating leverage would be

= $ 128,562.5 / $ 85,562.5

= 1.50 Approximately.

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