Question

OceanGate sells external hard drives for $400 each. Its total fixed costs are $60 million, and its variable costs per unit are $240. The corporate tax rate is 30%. If the economy is strong, the firm will sell 4 million drives, but if there is a recession, it will sell only half as many.

a. What will be the percentage decline in sales if the economy enters a recession?

	Percentage decline in sales %

b. What will be the percentage decline in profits if the economy enters a recession?

	Percentage decline in profit %

c. Comparing your answers to (a) and (b), how would you measure the operating leverage of this firm?

	Operating leverage

Answer 1

First of all, let us convert the million in to lakhs for the purpose of easiness of doing the math.

We know that 1 million = 10 lakh.

Now, considering the first scenario that the economy is strong. Hence, the company will sell 4 million drives. That is 40 lakh (4 * 10 lakh) drives.

Then the calculation will be as follows:

Sales = 40,00,000 drives * $400.00 per drives = $1,60,00,00,000.00

Variable Cost = 40,00,000 drives * $240.00 per drives = $96,00,00,000.00

We know that Sales - Variable Cost gives Contribution.

Therefore, Contribution = $1,60,00,00,000.00 - $96,00,00,000.00 = $64,00,00,000.00

Contribution - Fixed Cost = Profit

Here, the fixed cost given is $6,00,00,000.00

So, Profit = $64,00,00,000.00 - $6,00,00,000.00 = $58,00,00,000.00

Now, we have to find out what will be the sales and profit if the economy enters a recession.

If the economy enters a recession, it is stated in the question that the firm will sell only half.

So, the Sales will be 20,00,000 drives (i.e. 40,00,000 / 2).

Hence, the Sales in Value = 20,00,000 drives * $400.00 per drives = $80,00,00,000.00

Then the Variable Cost = 20,00,000 drives * $240.00 per drives = $48,00,00,000.00

So, Contribution = $80,00,00,000.00 - $48,00,00,000.00 = $32,00,00,000.00

It is to be understood that the fixed cost will not change and it will be constant irrespective of whatever the sales volume. So, here also, the fixed cost will be $6,00,00,000.00.

Therefore, Profit = $32,00,00,000.00 - $6,00,00,000.00 = $26,00,00,000.00

a) Percentage decline in sales if the economy enters a recession:

Percentage decline = [{($1,60,00,00,000.00 - $80,00,00,000.00) / $1,60,00,00,000.00} * 100] = 50%

b) Percentage decline in profits if the economy enters a recession:

Percentage decline = [{(58,00,00,000.00 - $26,00,00,000.00) / $58,00,00,000.00} * 100] = 55.17%

c) Under the recession scenario, calculation of operating leverage of the firm:

We know that Operating Leverage = Contribution / Net Operating Income

Here, it is to be noted that net operating income means profit before taxes. So, the arrived profit under recession scenario before adjusting the tax element will be taken for the purpose of computation.

Therefore, Operating Leverage = ($32,00,00,000.00 / $26,00,00,000.00) * 100 = 123%