Question

Question 4:

Footwear Inc. manufactures a complete line of men’s women’s dress shoes for independent merchants. The average selling price of its finished product is $84 per pair. The variable cost for this same pair of shoes is $42. Footwear Inc. incurs fixed costs of $168,000 per year.

a) Calculate the profit or loss at the following units of production sold: 7,000 pairs of shoes? 9,000 pairs of shoes? b) Calculate the operating leverage. c) What is the meaning of operating leverage? Explain how operating leverage affects both profitability and risk of the firm.

Answer 1

a)

	7000 pairs	9000 pairs
Sales( units*SP)	7000* 84 = $588000	9000*84 = $756000
(-) Variable cost ( units * VC)	7000* 42 = $294000	9000*42 = $ 378000
Contribution	$294000	$378000
(-) Fixed cost	$168000	$168000
EBIT ( profit)	$126000	$210000

b)  

	7000 pairs	9000 pairs
Contribution	$294000	$378000
EBIT	$126000	$210000
OPERATING LEVERAGE ( Contribution/ EBIT)	294000/126000 = 2.33 times	378000/210000 = 1.8times

c) Operating leverage = Operating leverage means relationship between fixed and varible cost with sales. It shows wheater revenue can be generated to cover the costs.

High OL leverage shows high costs means more revenue are needed to cover the costs.Low OL shows low costs means less revenue is needed. High OL means less profits whreas Low OL means high profits.

OL can also be used to measure business risk. High OL means high costs which leads to high business risk whereas low OL means low costs which leads to low business risk.