Question

Modern Artifacts can produce keepsakes that will be sold for $40 each. Nondepreciation fixed costs are $600 per year, and variable costs are $30 per unit. The initial investment of $1,800 will be depreciated straight-line over its useful life of 6 years to a final value of zero, and the discount rate is 8%.

a. What is the degree of operating leverage of Modern Artifacts when sales are $4,000? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. What is the degree of operating leverage when sales are $7,360? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

c. Why is operating leverage different at these two levels of sales?

Answer 1

Initial Investment = $1,800
Useful Life = 6 years

Depreciation = Initial Investment / Useful Life
Depreciation = $1,800 / 6
Depreciation = $300

Contribution Margin per unit = Selling Price per unit - Variable Cost per unit
Contribution Margin per unit = $40 - $30
Contribution Margin per unit = $10

Answer a.

Number of Units Sold = Sales / Selling Price per unit
Number of Units Sold = $4,000 / $40
Number of Units Sold = 100

Contribution Margin = Number of Units Sold * Contribution Margin per unit
Contribution Margin = 100 * $10
Contribution Margin = $1,000

Operating Income = Contribution Margin - Fixed Cost - Depreciation
Operating Income = $1,000 - $600 - $300
Operating Income = $100

Degree of Operating Leverage = Contribution Margin / Operating Income
Degree of Operating Leverage = $1,000 / $100
Degree of Operating Leverage = 10.00

Answer b.

Number of Units Sold = Sales / Selling Price per unit
Number of Units Sold = $7,360 / $40
Number of Units Sold = 184

Contribution Margin = Number of Units Sold * Contribution Margin per unit
Contribution Margin = 184 * $10
Contribution Margin = $1,840

Operating Income = Contribution Margin - Fixed Cost - Depreciation
Operating Income = $1,840 - $600 - $300
Operating Income = $940

Degree of Operating Leverage = Contribution Margin / Operating Income
Degree of Operating Leverage = $1,840 / $940
Degree of Operating Leverage = 1.96

Answer c.

Degree of operating leverage is higher when profits are lower.