Question

Modern Artifacts can produce keepsakes that will be sold for $130 each. Nondepreciation fixed costs are $1,600 per year, and variable costs are $80 per unit. The initial investment of $4,800 will be depreciated straight-line over its useful life of 6 years to a final value of zero, and the discount rate is 13%. 

a. What is the degree of operating leverage of Modern Artifacts when sales are $7,020? (Do not round intermediate calculations. Round your answer to 2 decimal places.) Degree of operating leverage 

b. What is the degree of operating leverage when sales are $13,000? (Do not round intermediate calculations. Round your answer to 2decimal places.) Degree of operating leverage 

c. Why is operating leverage different at these two levels of sales? Degree of operating leverage is when profits

Answer 1

Answer of Part a:

Depreciation = Initial Investment / No. of useful life
Depreciation = $4,800 / 6
Depreciation = $800

No. of Units = Selling price / Selling price per unit
No. of Units = $7,020 / $130
No. of Units = 54

Variable Cost = No. of Units * Variable Cost per unit
Variable Cost = 54 * $80
Variable Cost= $4,320

Profits = Revenues – Variable Cost – Fixed Costs – Depreciation
Profits = $7,020 - $4,320 - $1,600 - $800
Profits = $300

Degree of Operating Leverage = 1 + (Fixed Costs + Depreciation) / Profits
Degree of Operating Leverage = 1 + ($1,600 + $800) / $300
Degree of Operating Leverage = 1 + $2,400 / $300
Degree of Operating Leverage = 1 + 8
Degree of Operating Leverage = 9

Answer of Part b:

No. of Units = Selling price / Selling price per unit
No. of Units = $13,000 / $130
No. of Units = 100

Variable Cost = No. of Units * Variable Cost per unit
Variable Cost = 100 * $80
Variable Cost= $8,000

Profits = Revenue – Variable Costs – Fixed Costs – Depreciation
Profits = $13,000 - $8,000 - $1,600 - $800
Profits = $2,600

Degree of Operating Leverage = 1 + (Fixed Costs + Depreciation) / Profits
Degree of Operating Leverage = 1 + ($1,600 + $800) / $2,600
Degree of Operating Leverage = 1 + $2,400 / $2,600
Degree of Operating Leverage = 1 + 0.92
Degree of Operating Leverage = 1.92

Answer c.

Fixed costs are constant. So, small change in sales revenue will lead to big change in profit which is the main reason for different operating leverage.