Question

PneumoTech, Inc. is studying the addition of a new valve to its product line. The valve would be used by manufacturers of pneumatic equipment. The company anticipates starting with a relatively low sales volume and then boosting demand over the next several years. A new salesperson must be hired because PneumoTech's current sales force is working at capacity. Two compensation plans are under consideration:

           Plan A:    An annual salary of $33,000 plus a 10% commission based on gross dollar sales.

           Plan B:    An annual salary of $99,000 and no commission.

PneumoTech, Inc. will purchase the valve for $75 and sell it for $120. Anticipated demand during the first year is 6,000 units. (In the following requirements, ignore income taxes.)

Required:

1. Compute PneumoTech's break-even point for Plan A and Plan B.

2. What is meant by the term operating leverage?

3. Analyze the cost structures of both plans at the anticipated demand of 6,000 units. Which of the two plans is more highly leveraged? Why?

4. Assume that a general economic downturn occurred during year 2, with product demand falling from 6,000 to 5,000 units. Determine the percentage decrease in company net income if PneumTech had adopted Plan A.

5. Repeat requirement (4) for Plan B. Compare Plan A and Plan B, and explain a major factor that underlies any resulting differences.

6. Briefly discuss the likely profitability impact of an economic recession for highly automated manufacturers. What can you say about the risk associated with these firms?

Answer 1

Solution

PneumoTech Inc

1. Computation of the PneumoTech’s break-even point for Plan A and Plan B:

Break-even point (units) = fixed cost/contribution margin per unit

Break-even point for Plan A –

Sales price                              $120

Variable cost –

Valve purchase price $75

Salesperson salary      $12      (10% of $120)

Total variable cost      $87

Contribution margin               $120 - $87 = $33

Fixed cost       - annual salary of salesperson = $33,000

Break-even point = $33,000/$33 = 1,000 units

Break-even point for Plan B –

Sales price                              $120

Variable cost –                      

Purchase price of valve          $75

Contribution margin               $45

Fixed cost – annual salary of salesperson = $99,000

Break-even point = $99,000/$45 = 2,200 units

1. Operating Leverage:

Operating leverage refers to the proportion of fixed and variable costs used by a firm in its cost structure.

Degree of operating leverage is expressed as follows, Contribution margin/net operating income.

Degree of operating leverage aims to measure the impact of change in sales volume on a firm’s profit level. A high operating leverage indicates high change in profit with changes in sales volume and low operating leverage indicates low change in profit with changes in sales volume.

High fixed cost indicates high operating leverage and low fixed cost indicates low operating leverage.

1. Analysis of cost structures of both plans at the anticipated demand of 6,000 units and determination of the leverage of both the plans:

		Plan A	Plan B
Sales		$720,000	$720,000
Variable cost		$522,200	$450,000
Contribution margin		$198,000	$270,000
Fixed cost		$33,000	$99,000
Net Operating Income		$165,000	$171,000
Degree of operating leverage		$198,000/$165,000	$270,000/$171,000
		1.2	1.6

1. Sales is calculated as follows,

Sales price $120 x 6,000 units = $720,000

1. Variable cost is calculated as follows,

Plan A - $87 (as determined in 1. Above) x 6,000 = $522,200

Plan B - $75 (as determined in 1. Above) x 6,000 = $450,000

Analysis – Plan B (operating leverage 1.6) is highly leveraged than Plan A (operating leverage1.2) owing to the high fixed cost proportion ($99,000) in Plan B.

1. Determination of the percentage decrease in company net income if the company adopts Plan A:

Decrease in sales volume = 6,000 – 5,000 units = 1,000 units

Percentage decrease = (1,000/6,000) x 100 = 16.67%

Percentage decrease in sales volume = percent change in sales volume x operating leverage

                        = 16.67% x 1.2 = 20%

Hence, a 16.67% decrease in sales volume results in 20% decrease in PneumoTech’s net income if the company adopts Plan A.

1. Determination of the percentage decrease in company net income if the company adopts Plan B:

Decrease in sales volume = 6,000 – 5,000 units = 1,000 units

Percentage decrease = (1,000/6,000) x 100 = 16.67%

Percentage decrease in sales volume = percent change in sales volume x operating leverage

                        = 16.67% x 1.6 = 26.67%

Hence, a 16.67% decrease in sales volume results in 26.67% decrease in PneumoTech’s net income if the company adopts Plan B.

The major factor affecting the change in profit levels with the change in sales volume is the proportion of fixed cost in both Plan A and Plan B.

In Plan A, the proportion of fixed cost ($33,000) is relatively lower compared to Plan B ($99,000) and hence the operating leverage is also lower. Consequently, the profit levels decreased higher in Plan B as compared to Plan A.