McGraw Hills Corporation sells managerial accounting textbooks. Fixed costs are $120,000 and variable costs per unit...

McGraw Hills Corporation sells managerial accounting textbooks. Fixed costs are $120,000 and variable costs per unit are $20. McGraw Hills is considering the purchase of new equipment that would reduce hourly labor. However, total costs will remain the same. What effect would the purchase of the new equipment have on McGraw Hills’ operating leverage?

A) No effect. Operating leverage will stay the same because total costs do not change.

B) Operating leverage will increase.

C) Operating leverage will decrease.

D) The problem does not provide enough information to answer the question

Solutions

Expert Solution

Answer)

The correct answer is Option (B) i.e. operating leverage will increase.

The formula for degree of Operating leverage is:

Degree of operating leverage = Contribution margin/ Operating income

Impact on following items will be:

· Operating Income: it specified in the question that total cost of the company will remain same. Since operating income is the difference between sales and total cost, it implied that Operating income will also remain same.

· Fixed cost and Variable cost: with the purchase of machine, fixed cost will increase. Since total cost will remain same, variable cost will fall and as the hourly labor reduces, variable cost per unit will reduce.

· Contribution margin: With the reduction in variable cost, contribution margin will increase.

As explained above, with the purchase of new equipment, contribution margin will increase and operating income will remain same. Putting these values in the following formula, it can be said that the degree of operating leverage will increase.

Degree of operating leverage = Contribution margin/ Operating income

ekkarill92 answered 1 year ago

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