Question

The Sterling Tire Company’s income statement for 20XX is as follows:

STERLING TIRE COMPANY Income Statement Year ended December 31, 20XX
Sales (20,000 tires at $60 each)	$	1,200,000
Less: Variable costs (20,000 tires at $30)		600,000
Contribution margin		600,000
Less: Fixed costs		400,000
Earnings before interest and taxes (EBIT)		200,000
Interest expense		50,000
Earnings before taxes (EBT)		150,000
Income tax expense (34%)		51,000
Earnings after taxes (EAT)	$	99,000

Given this income statement, compute the following:

a. Degree of operating leverage. (Round the final answer to 2 decimal places.)

DOL             X

b. Degree of financial leverage. (Round the final answer to 2 decimal places.)

DFL             X

c-1. Degree of combined leverage. (Do not round the intermediate calculations. Round the final answer to 2 decimal places.)

DCL             X

c-2. Using your answers to a. and b. calculate the percentage increase in EBIT and EBT from a 20 percent increase in sales volume. (Do not round the intermediate calculations. Round the final answers to 2 decimal places.)

EBIT	%
EBT	%

c-3. Does financial or operating leverage have the greater impact?

multiple choice

• DFL

• DOL

d. Break-even point in units. (Round the final answer to the nearest whole number.)

Break-even point             tires

e. Break-even point considering the interest expense as a fixed cost.

Break-even point             tires

Answer 1

a. Degree of operating leverage = Contribution margin/Earnings before interest and Taxes (EBIT)

Degree of operating leverage = $600,000/$200,000 = 3.00

b. Degree of financial leverage = Earnings before interest and Taxes (EBIT)/(Earnings before interest and Taxes (EBIT) - Interest)

Degree of financial leverage = $200,000/($200,000 - $50,000) = $200,000/$150,000 = 1.333333333333333 or 1.33

c-1. Degree of combined leverage = Degree of operating leverage*Degree of financial leverage

Degree of combined leverage = 3.00*1.333333333333333 = 4.00

c-2. percentage increase in EBIT = Degree of operating leverage*percent increase in sales volume

percentage increase in EBIT = 3.00*0.20 = 0.60 or 60.00%

percentage increase in EBT = Degree of combined leverage*percent increase in sales volume

percentage increase in EBT = 4.00*0.20 = 0.80 or 80.00%

c-3. Answer is DOL.

Degree of operating leverage have greater impact because it is higher than Degree of financial leverage.

d. Break-even point in units = Fixed costs/(selling price per tire - Variable cost per tire)

Break-even point in units = $400,000/($60 - $30) = $400,000/$30 = 13,333

Break-even point in units is 13,333 tires.