Question

A project has fixed costs of $1,500 per year, depreciation charges of $500 a year, annual revenue of $9,000, and variable costs equal to two-thirds of revenues.

a. If sales increase by 13%, what will be the percentage increase in pretax profits? (Round to 2 decimal places)

b. What is the degree of operating leverage of this project? (round to 2 decimal places)

Answer 1

a) Fixed Cost= $ 1,500
Annual Revenue(Sales)= $9,000
Variable Cost= 2/3 of revenue i.e. 9000*2/3= $6000

Sales after increase of 13% = 9000*13%=1170
= 9000+1170=$10,170
Variable cost after increase in sales = 10170*2/3
= $ 6780   

Particulars	Amount	Amount after increase in sales by 13%
Sales	$9,000	$10,170
less: Variable Cost	$6,000	$6,780
Contribution	$3,000	$3,390
less: Fixed Cost	$1,500	$1,500
EBIT	$1,500	$1,890
less: Interest	0	0
EBT(Pre-tax Profit)	$1,500	$1,890

Now,

% increase in EBIT (Pre-Tax Profit) ; (New EBIT-Old EBIT) / Old EBIT

= $1890-$1500= $390 / $1500
=   390/1500
= 0.26 * 100
= 26%
There will be a 26% increase in Pre tax profit after increase in 13% sales.

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b) Degree of Operating Leverage : It measures how much the operating income of a company will change in response to a change in sales. It determines the impact of change in sales on company's earnings .

Degree of Operating Leverage= % change in sales / % change in EBIT​
where, EBIT= Earning before interest and tax

so , in the above question , degree of operating leverage ;

% change in sales= $10170 - $9000 = $1170
= 1170 / 9000
= 0.13 * 100
= 13%

% change in EBIT= $1890 - $1500 = $390
= 390 / 1500
= 0.26 * 100
= 26%
Degree of Operating Leverage = 0.13 / 0.26
= 0.5