Question

Pick two companies in the same industry.

a. Determine their DOL, DFL, and DCL.

b. What effect does a change in sales have on their operating income?

c. What effect does a change in sales have on earnings per share?

Answer 1

Let's pick up two comparable die hard competitor from FMCG sector. I have chosen The Coca Cola Company and the Pepsico.

1. Select financials for the Coca Cola Company had been retrieved from "https://www.nasdaq.com/symbol/ko/financials?query=income-statement", on 7th April 2019
2. Select financials fro Pepsico. had been retrieved from https://www.nasdaq.com/symbol/pep/financials", on 7th April 2019

Please see the select financials and then calculations.

Part (a)

Before we get into the calculations, let's recall the formulae for DOL, DFL and DCL.

DOL = Contribution / (Contribution - Fixed costs)

DFL = Operating income / (operating income - Interest)

DCL = DOL x DFL

Let's look into the table below. Please see the second column. That will help you understand how each of the values had been calculated. The answers are in yellow highlighted cells.

Parameter	Linkage	The Coca Cola Company	PepsiCo
Revenues	A	31,856,000	64,661,000
Cost of Revenues (=Variable costs)	B	11,770,000	29,381,000
Gross Profit (=Total Contribution)	C = A - B	20,086,000	35,280,000
Sale, General & Admin expenses (= Fixed Costs)	D	11,386,000	25,170,000
Operating income	E = C - D	8,700,000	10,110,000
Interest	F	919,000	1,525,000
DOL	=C / (C - D)	2.3087	3.4896
DFL	=E / (E - F)	1.1181	1.1776
DCL	=DOL x DFL	2.5814	4.1095

Part (b)

Change in sales have same directional impact on operating income:

• A reduction in sales translate into a reduction in operating income
• An increase in sale leads to improvement in the operating income
• In our case the companies have DOL in excess of 2 & 3. This simply means:
  • A 1% reduction in sales leads to a reduction of 2.31% in the operating income of the Coca Cola Company. While operating income of Pepsico declines by 3.49%.
  • Similarly an increase of 1% in sales will lead an increase of 2.31% and 3.49% in the operating income of the two companies respectively.

Part (c)

Change in sales will again have the direction impact on EPS

• A reduction in sales translate into a reduction in EPS
• An increase in sale leads to improvement in the EPS
• In our case both the companies have DCL of 2.58 and 4.11 respectively. This simply means:
  • A 1% reduction in sales leads to a reduction of 2.58% in the EPS of the Coca Cola Company. While the EPS of Pepsico declines by 4.11%.
  • Similarly an increase of 1% in sales will lead an increase of 2.58% and 4.11% in the EPS of the two companies respectively.