Question

Please add explanations

6. What is the degree of operating leverage? Sales = 100,000 units; price = $50; variable cost = $30; fixed costs = $950,000; depreciation = $250,000; tax rate = 34%.

A) 1.06

B) 1.22

C) 1.37

D) 1.63

E) 2.22

Answer 1

Ans) Operating leverage is an efficiency ratio that tells how well the fixed cost of the firm is being used in order to generate profits. Revenues are used to cover 1st variable cost and then fixed cost. when a firms revenue is able to covere both variable cost and fixed cost fully that level of revenue is call break even point of revenue. Any amount of revenue earned over and above covering both variable and fixed cost is the profit for the firm.

A higher fixed cost implies a higher operating leverage as at remains constant and helps to increase profits as sale increases. High variable cost on the other hand results in low operating leverage as it increases with the increase insale and results in lower profits.

Degree of Operating Leverage = Amount left to cover fixed costs of the firm / profits after covering fixed and variable costs

in formula terms,

Degree of operating leverage = revenue - variable costs / revenue - variable costs - fixed costs

= sales (price - variable cost) / sales(price - variable cost) - fixed cost

= 1,00,000 ( $50 - $30) / 1,00,000 ( $50 - $30) - 9,50,000 - 2,50,000 {since

depriciation is a fixed cost}

= 20,00,000 / 8,00,000 = 2.5

Therefore the degree of operating Leverage = 2.5