Question

One of the subsidiary of the company Dronedelivery Sdn Bhd is producing delivery drones. With the existing technology, their variable per unit is $480 and annual fixed cost, including maintenance expenses, total $1,120,000. However, with the proposed new technology variable costs, are projected to be cut in half to $240 per unit while fixed costs are expected to double to $3,240,000. Given the anticipated new costs structure and no change in the pricing structure of the drones, the breakeven level of sales is expected to increase from 3800 units currently to 4300 units with the new production method. Current sales are 4000 units an average price of $800. They figure out that 6,000 units is a reasonable expected sales level, with standard deviation of above 1,100 units. You might think 6,000 units is an overly optimistic sales forecast, but with our large and growing backlog of orders they have every confidence that they will make or exceed 6,000 unit target. Required a) Calculate the degree of operating leverage (DOL) for the company? b) Based on the DOL and the risk profile of the product and the demand, should the company move to adopt the new technology? The new technology will cost $20,000,000 with a useful life of 4 years. The existing technology has a net book value of $10,000,000 and a useful life of also 4 years. c) What are the qualitative considerations that you must take in decision?

Answer 1

a) Calculation of Degree of Operating Leverage:

DOL = Percentage change in EBIT / Percentage change in Sales

current Sales are $32,00,000 ( 4000 units X $8000 ),   

Variable costs are $19,20,000 (4000 units x $480)

Contribution = 12,80,000

Less fixed costs = 11,20,000

EBIT = 1,60,000

With new technology

Sales are $48,00,000 ( 6000 units X $8000 ),

Less Variable costs are $14,40,000 (6000 units x $240)

Contribution = 33,60,000

Less fixed costs = 32,40,000

   EBIT = 1,20,000

Change in EBIT is (1,20,000 - 1,60,000 ) / 1,60,000 = - .3333

Change in sales is ( 48,00,000 - 32,00,000 ) / 32,00,000= 0.5

Degree of Operating Leverage is -.33 /0.50 = -0.66

b) Based on the DOL and the risk profile of the product and the demand, it is advisable for the company to not to adopt the new technology. This DOL is negative. It means change in sales by one dollar will only reduce the EBIT by $ 0.33. So the Company should not adopt new technology.   

c) Qualitative considerations for the decision:

Though the company is very confident of making sales of 6000 units with the adoption of new technology, given the variation in the demand of 1,100 units with more than double increase in the fixed costs, the company will be at a great risk if it proceeds to go in for adoption of new technology.