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?

PLEASE HELP ME. THANK YOU SO MUCH!!

Answer 1

A)

Degree of Operating Leverage (DOL) = Contribution / EBIT

Degree of Operating Leverage (DOL) = 292500/107500

Degree of Operating Leverage (DOL) =2.72

B)

Degree of Financial Leverage measure percentage change in income due to given percentage change in EBIT

Degree of Financial Leverage = EBIT / INCOME

Degree of Financial Leverage =107500/50000

Degree of Financial Leverage = 2.15

2.15% will Income change for each 1% deviation in EBIT

C)

Income Statement
Sales	$ 520,000.00
Variable Cost	$ 286,000.00	=357500*520000/650000
Contribution	$ 234,000.00	=520000-286000
Fixed Costs	$ 185,000.00
EBIT	$    49,000.00	=234000-185000
Interest	$    57,500.00
EBT	$    (8,500.00)	=49000-57500

PERCENTAGE (%) will Income decrease under the company’s present financial model = ((-8,500 -50,000)/50,000)

PERCENTAGE (%) will Income decrease under the company’s present financial model = 117.00%

D)

Survival Breakeven Sales Volume = Total Fixed Cost / PV Ratio

Total Fixed Cost = Fixed Cost + Interest

Total Fixed Cost = 185,000 + 57,500

Total Fixed Cost = $242,500

PV Ratio = Contribution / Sales

PV Ratio = $292,500 / $650,000

PV Ratio = 45%

Survival Breakeven Sales Volume = Total Fixed Cost / PV Ratio

Survival Breakeven Sales Volume = $242,500 / 45%

Survival Breakeven Sales Volume = $    538,888.89

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