Question

A new business has developed its preliminary business model.   It expects to incur BOTH fixed operating and financial costs; and the model projects Year 1 Sales of $650,000 (but team members think that Sales could be as low as $500,000 or as high as $900,000). The owners want to know what will happen to profits if the model Sales projection is incorrect. The primary concern is Sales less than $650,000 given the substantial fixed costs the model accepts. The Year 1 proforma Income Statement is as follows:

Sales                                        650,000                                                                                  

Variable Expense                      357,500

Gross Profit                              292,500

Fixed Expenses                         185,000

EBIT                                          107,500

Less: Fixed Financial Expenses 57,500

Income                                    50,000

Note: Ignore Depreciation and Taxes

a) Given the company’s projected Sales and its expense structure, what Degree of Operating Leverage (DOL) is the company willing to accept?

b) Given the fixed financial costs in the company model, by what % will Income change for each 1% deviation in EBIT?  

c) If actual sales are $520,000, by what PERCENTAGE (%) will Income decrease under the company’s present financial model? (Make sure you answer the correct question.)

d) What is the company’s Survival Breakeven Sales Volume?

Thank you so much!!

Answer 1

a)

The Degree of Operating leverage = Change in Gross Profit / Change in sale

if sale is decreased to 500000

Degree of operating leverage = 292500-225000/650000-500000 = 67500/150000 = 45%

if sale is increased to 900000

Degree of operating leverage = 405000-292500/900000-650000= 112500/250000= 45%

Hence the firm is willing to accept 45% of degree of Operating leverage.

b) To compute "by what % will Income change for each 1% deviation in EBIT"

We will have to compute Degree of financial leverage

Degree of Financial leverage = EBIT divided by EBIT-Interest expense

=107500/(107500-57500) = 2.15 times

Hence for every 1% change in EBIT the income will change by 2.15%

C) If there is decrease in sales then the decrease in income will be equal to degree of operational leverage i.e. 45%

Calculation

d) Break even sale volume (We have assumed sale price is 1 per unit )= Fixed cost divided by Contribution

= 185000+57500/ 292500 = 57500 units approx