Question

20. Given the following information on two different firms, (a) calculate the breakeven output of each firm.

Firm 1                                                             Firm 2            

P                      TFC                 AVC                P                                  TFC                 AVC

$10.00             $50.00             $6.00               $10.00                         $100.00            $3.33

Breakeven output                                            Breakeven output

Firm 1 = _________ units                              Firm 2 = _________ units

                                                                                   

(b) Calculate the degree of operating leverage for each practice at Q = 50 and Q = 80.

                       

DOL(50) = _______                                              DOL’(50) = _______

                                                                                   

                                    DOL(80) = _______                                              DOL’(80) = _______

Which practice is more leveraged? Why? What does a greater degree of leverage imply?

Answer 1

a.) Break even output= FC/(p-VC)

Firm 1= 50/(10-6)= 50,000/4= 12.5 units

Firm 2= 100/(10-3.33)= 14.99 or 15 units

b.)

For firm 1

At Q=50, sales= 50*10= 500

VC= 6*50= 300

FC=50

Sales-VC-FC= 500-300-50= 150

Sales-VC= 200

DOL=200/150= 1.33

At Q=80, sales= 80*10= 800

VC= 6*80= 480

FC=50

Sales-VC-FC= 800-400-50= 350

Sales-VC=400

DOL= 400/350= 1.14

Firm 2

At Q=50, sales= 50*10= 500

VC= 3.33*50= 166.5

FC=100

Sales-VC-FC= 500-166.5-100= 233.5

Sales-VC= 333.5

DOL= 333.5/233.5= 1.42

At Q=80, sales= 80*10= 800

VC= 3.33*80= 266.4

FC=100

Sales-VC-FC= 800-266.4-100= 433.6

Sales-VC= 533.6

DOL= 533.6/433.6= 1.23

Firm 2 producing 50 units is more leveraged, because of higher fixed cost and lower production.

Higher DOL value implies high risk and increased sensitivity.