Question

Arnold Vimka is a venture capitalist facing two alternative investment opportunities. He intends to invest $1 million in a start-up firm. He is nervous, however, about future economic volatility. He asks you to analyze the following financial data for the past year’s operations of the two firms he is considering and give him some business advice.

	Company Name
	Larson				Benson
Variable cost per unit (a)	$	21.00			$	10.50
Sales revenue (8,900 units × $30.00)	$	267,000			$	267,000
Variable cost (8,900 units × a)		(186,900	)			(93,450	)
Contribution margin	$	80,100			$	173,550
Fixed cost		(24,800	)			(118,250	)
Net income	$	55,300			$	55,300

Required

1. Use the contribution margin approach to compute the operating leverage for each firm.

2. If the economy expands in coming years, Larson and Benson will both enjoy a 12 percent per year increase in sales, assuming that the selling price remains unchanged. Compute the change in net income for each firm in dollar amount and in percentage. (Note: Since the number of units increases, both revenue and variable cost will increase.)

3. If the economy contracts in coming years, Larson and Benson will both suffer a 12 percent decrease in sales volume, assuming that the selling price remains unchanged. Compute the change in net income for each firm in dollar amount and in percentage. (Note: Since the ­number of units decreases, both total revenue and total variable cost will decrease.)

Answer 1

Answer:

Degree of Operating Leverage = Contribution Margin / Net Income

Degree of Operating Leverage = % Change in Net Income / % Change in Sales

Degree of Operating Leverage for Larson = $80,100 / $55,300 = 1.44

Degree of Operating Leverage for Benson = $173,550 / $55,300 = 3.13

12% Increase

Revised No.of Units after 12% Increase

= 8,900 units * 112% = 9,968 units

Revised Sales for both entities = 9,968 units * $30 = $299,040

Revised Net Operating Income (Dollars)

Change in Net Income (Dollars) for Larson = $64,912 - $55,300 = $9,612

Change in Net Income (Dollars) for Benson = $76,126 - $55,300 = $20,826

Degree of Operating Leverage = % Change in Net Income / % Change in Sales

% Change in Net Income for Larson

                                  1.44 = % Change in Net Income / 0.12

           % Change in Net Income = 1.44 * 0.12

                                                          = 0.1738    or    17.38%

% Change in Net Income for Benson

                                  1.44 = % Change in Net Income / 0.12

           % Change in Net Income = 3.13 * 0.12

                                                          = 0.3766 or    37.66%

12% Decrease

Revised No.of Units after 12% Increase

= 8,900 units * 88% = 7,832 units

Revised Sales for both entities = 7,832 units * $30 = $234,960

Revised Net Operating Income (Dollars)

Change in Net Income (Dollars) for Larson = $45,688 - $55,300 = ($9,612)

Change in Net Income (Dollars) for Benson = $34,474 - $55,300 = ($20,826)

Degree of Operating Leverage = % Change in Net Income / % Change in Sales

% Change in Net Income for Larson

                                  1.44 = % Change in Net Income / 0.12

           % Change in Net Income = 1.44 * 0.12

                                                          = 0.1738    or    17.38%

% Change in Net Income for Benson

                                  1.44 = % Change in Net Income / 0.12

           % Change in Net Income = 3.13 * 0.12

                                                          = 0.3766 or    37.66%

As there is a decrease in Sales percentage the change in Operating leverage percentage will also be negative.