In: Finance
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!!
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