In: Finance
A project has fixed costs of $2,400 per year, depreciation charges of $300 a year, annual revenue of $21,600, and variable costs equal to two-thirds of revenues.
a. If sales increase by 19%, what will be the percentage increase in pretax profits?
b. What is the degree of operating leverage of this project?
Revenue | $ 21,600 | |
Less: Variable cost | (2/3 of revenue) |
$ (14,400) |
Contribution | $ 7,200 | |
Less: Depreciation | $ (300) | |
Less: Fixed Cost | $ (2,400) | |
$ 4,500 |
a. Sales increase by 19%; percentage increase in pretax profits?
Revenue | (21600*1.19) | $ 25,704 |
Less: Variable cost | (2/3 of revenue) | $ 17,136 |
Contribution | $ 8,568 | |
Less Depreciation | $ (300) | |
Less Fixed Cost | $ (2,400) | |
$ 5,868 |
Increase in pretax profit = (5868 - 4500) / 4500 = 1368 / 4500 = 0.304
Hence, Increase in pretax profit = 30.40%
b. Degree of operating leverage of project
Original structure | Sales increase 19% | ||
Revenue | $ 21,600 | $ 25,704 | |
Less: Variable cost | (2/3 of revenue) | $ 14,400 | $ 17,136 |
Contribution | $ 7,200 | $ 8,568 | |
Less Fixed Cost | $ (2,400) | $ (2,400) | |
Net Operating income (NOI) | $ 4,800 | $ 6,168 | |
Operating leverage | Contribution / NOI | =7200 / 4800 | =8568 / 6168 |
1.50 | 1.39 |