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)	$	18.00			$	9.00
Sales revenue (9,000 units × $31.00)	$	279,000			$	279,000
Variable cost (9,000 units × a)		(162,000	)			(81,000	)
Contribution margin	$	117,000			$	198,000
Fixed cost		(24,900	)			(105,900	)
Net income	$	92,100			$	92,100

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 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.)

3. 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

1.
Operating Leverage = Contribution Margin / Net Income
Larson = $117000 / 92100 = 1.27
Benson = $198000 / 92100 = 2.15

2.

	Larson	Benson
Variable Cost per unit	$                18	$                   9
Sales Revenue	$      306,900	$      306,900
Variable Cost	$      178,200	$         89,100
Contribution Margin	$      128,700	$      217,800
Fixed Cost	$         24,900	$      105,900
Net Income	$      103,800	$      111,900
Percentage Change	12.70%	21.50%
Change in Net Income	$         11,700	$         19,800

Larson
Change in Net Income (%) = 1.27 x 10% = 12.70%
Change in Net Income = $92100 x 12.7% = $11696 or 11700

Benson
Change in Net Income (%) = 2.15 x 10% = 21.50%
Change in Net Income = $92100 x 21.5% = $19802 or $19800

3.

	Larson	Benson
Variable Cost per unit	$                18	$                   9
Sales Revenue	$      251,100	$      251,100
Variable Cost	$      145,800	$         72,900
Contribution Margin	$      105,300	$      178,200
Fixed Cost	$         24,900	$      105,900
Net Income	$        80,400	$        72,300
Percentage Change	-12.70%	-21.50%
Change in Net Income	$       (11,700)	$       (19,800)

Larson
Change in Net Income (%) = 1.27 x 10% = -12.70%
Change in Net Income = $92100 x 12.7% = ($11696) or (11700)

Benson
Change in Net Income (%) = 2.15 x 10% = -21.50%
Change in Net Income = $92100 x 21.5% = ($19802) or ($19800)