Question

Fred and Bob own a medium size water delivery firm named W Corp. and they are each 50% partners. They have a 10,000 square foot factory with rent of 12k per month. They currently lease 3 trucks at $850 each per month and have 3 salaried employees they pay 25k each annually to operate their trucking routes. Sales are 800k per year, Contribution Margin is 500k per year and EBIT is 250k. They have no debt.

A. What is their DOL?

B. How can the DOL be lowered?

C. What will most likely happen to the firm if sales drop by half in regards to DOL and chapter 11 risk

Answer 1

A. DOL = 2

B. DOL or Degree of Operating Income measures the change in Operating Income (EBIT) for a change in sales. Since variable costs vary with respect to sales and fixed costs remain same irrespective of any change in sales, the impact on change in sales on the Operating Income will depend on the degree of fixed costs of the firm.

The firm has a high DOL of 2. This means that for every 1% change in sales, Operating Income will change by 2%. A high DOL is not recommended as it implies that Operating Income will be very volatile to the change in sales. Thus, to lower the DOL, the firm has to reduce the fixed costs with any or all of the following:

1. Explore if the number of trucks leased can be reduced

2. Evaluate if they can have fewer employees than 3

3. Check if they can move to a small size factory with reduced rental costs

C. If Sales Drop by half, Operating Income will reduce by 100% from 2 to 1 as follows:

DOL = Contribution Margin/Operating Income = ($500,000*(1-50%)) / (($500,000*(1-50%))-$249,600) = $250,000/$250.400 = 1

For the drop in sales, Contribution Margin (comprising variable costs as well) will drop by half but the fixed costs remain the same.

The firm has no debt and hence Chapter 11 risk (bankrupty risk), in its strict sense, is unlikely. However, considering payment for the fixed costs to be made, a 50% drop in sales will reduce the cash-inflows making it more difficult to pay for the fixed costs. This will eventually lead to delayed and failed payments making it difficult to run the business. Thus, the firm has to necessarily reduce its fixed costs as mentioned above.