Question

Spring Company’s cost structure is dominated by variable costs with a contribution margin ratio of 0.25 and fixed costs of $20,000. Every dollar of sales contributes 25 cents toward fixed costs and profit. The cost structure of a competitor, Winters Company, is dominated by fixed costs with a higher contribution margin ratio of 0.70 and fixed costs of $200,000. Every dollar of sales contributes 70 cents toward fixed costs and profit. Both companies have sales of $400,000 per month.

Required:

a. Compare the two companies’ cost structures.

b. Suppose that both companies experience a 15 percent increase in sales volume. By how much would each company’s profits increase?

Answer 1

a)

Cost structure comparison

There is no obvious answer to the question as to which cost structure is better-high fixed cost and low variable cost vice versa. Both have advantages and disadvantages.Depending on the specific circumstances of each case like yearly fluctuations in sale, long run trend in sales,stands towards risk and other factors,the choice has to be made. In this case company’s have same net operating income but different mixes of fixed and variable cost.

Suppose there is a 10 percent increase in sales without any increase in fixed cost. In such circumstances even though the increase in sales is same for both companies,the company having a low variable cost in its cost structure will be better off. Winter company is better off since the contribution Margin ratio is higher and its profit will therefore increase more rapidly as sales increase.

b)

Increase of profit in dollars and percentage after the increase in sales by 15%.

Spring company

95000-80000= $15,000

(18.75% of increase from $80,000)

Winters company

122000-80000=$42,000

( 52.5% of increase from $80,000)

Workings;

Note:

Operating leverage

Operating leverage measures sensitivity of net operating income to a percentage change in sales.

Degree of operating leverage (DOL)

=Contribution margin/net operating income