Question

Arnold Vimka is a venture capitalist facing two alternative investment opportunities. He intends to invest $800,000 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)	$	16.00			$	7.00
Sales revenue (8,000 units × $25)	$	200,000			$	200,000
Variable cost (8,000 units × a)		(128,000	)			(56,000	)
Contribution margin	$	72,000			$	144,000
Fixed cost		(24,000	)			(96,000	)
Net income	$	48,000			$	48,000

Required

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

If the economy expands in coming years, Larson and Benson will both enjoy a 10 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.)

If the economy contracts in coming years, Larson and Benson will both suffer a 10 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

Operating leverage:

		Company Name
Ref		Larson				Benson
	Variable cost per unit (a)		16				7
	Sales revenue (8,000 units × $25)		2,00,000				2,00,000
	Variable cost (8,000 units × a)		1,28,000				56,000
a	Contribution margin		72,000				1,44,000
	Fixed cost		24,000				96,000
b	Net income		48,000				48,000
c= a/b	Operating leverage		1.5				3

Sales volume increases by 10%

		Company Name
Ref		Larson				Benson
	Variable cost per unit (a)		16				7
	Selling price		25				25
	Units		8800				8800
	Sales revenue (8,000 units × $25)		2,20,000				2,20,000
	Variable cost (8,000 units × a)		1,40,800				61,600
a	Contribution margin		79,200				1,58,400
	Fixed cost		24,000				96,000
b	Net income		55,200				62,400
c	Original net income		48,000				48,000
d= b-c	Change in net income		7,200				14,400
e= d/c *100	Change in net income %		15%				30%

Sales volume decreases by 10%

		Company Name
Ref		Larson				Benson
	Variable cost per unit (a)		16				7
	Selling price		25				25
	Units		7200				7200
	Sales revenue (8,000 units × $25)		1,80,000				1,80,000
	Variable cost (8,000 units × a)		1,15,200				50,400
a	Contribution margin		64,800				1,29,600
	Fixed cost		24,000				96,000
b	Net income		40,800				33,600
c	Original net income		48,000				48,000
d= b-c	Change in net income		-7,200				-14,400
e= d/c *100	Change in net income %		-15%				-30%