Question

Two business sell an identical product for P=20.

Business 1 uses a process with a cost curve of TC = 10000 + x.

Business 2 uses a process with a cost curve of TC = 2000 + 2x.

Which business is likely to have a higher DOL?

Select one:

a. Business 1, because it has a higher contribution margin and higher fixed costs

b. Business 1, because it has a lower contribution margin and lower fixed costs

c. Business 2, because it has a higher contribution margin and higher fixed costs

d. Business 2, because it has a lower contribution margin and lower fixed costs

Answer 1

a. Business 1, because it has a higher contribution margin and higher fixed costs.

DOL Is the degree of operating leverage.

A business with higher fixed cost to variable cost proportion is expected to have a higher DOL.

Fixed costs:

Business 1 = 10000

Business 2 = 2000

Variable costs:

Business 1 = x

Business 2 = 2x

Ratio of fixed cost to variable costs:

Business 1 =10000/x

Business 2 =2000/2x

10000/x > 2000/2x for all x>0

So, business 1 has higher DOL

Businesses with higher contribution margin tend to have higher DOL.

Contribution margin is the part of revenue that is not consumed by variable costs and so contributes to cover the fixed costs. This can be obtained by subtracting variable cost per unit from the price of the good.

Variable Cost per unit of good:

Business 1 = 1

Business 2: = 2

Let price be p

Then contribution margin:

Business 1 = p-1

Business 2 = p-2

p-1> p-2 for all p>0

So, business has Higher contribution margin and higher fixed cost to variable cost ratio. So, it is likely to have higher DOL.