Question

Problem 2-23B Analysis of operating leverage

June Wade has invested in two start-up companies. At the end of the first year, she asks you to evaluate their operating performance. The following operating data apply to the first year:

	Company Name
	Cook	Penn
Variable cost per unit (a)	$ 16	$ 8
Sales revenue (8,000 units × $25)	$200,000	$200,000
Variable cost (8,000 units × a)	(128,000)	(64,000)
Contribution margin	72,000	136,000
Fixed cost	(40,000)	(104,000)
Net income	$ 32,000	$ 32,000

Required

Use the contribution margin approach to compute the operating leverage for each firm.

If the economy expands in the coming year, Cook and Penn will both enjoy a 10 percent per year increase in sales volume, assuming that the selling price remains unchanged. (Note: Since the number of units increases, both revenue and variable cost will increase.) Compute the change in net income for each firm in dollar amount and in percentage.

If the economy contracts in the following year, Cook and Penn will both suffer a 10 percent decrease in sales volume, assuming that the selling price remains unchanged. (Note: Since the number of units decreases, both revenue and variable cost decrease.) Compute the change in net income for each firm in both dollar amount and percentage.

Write a memo to June Wade with your evaluation and recommendations.

Answer 1

Operating Leverage = Contribution Margin / Net Income

1) Calculation of Operating Leverage :-

Particulars	Cook	Penn
Contribution Margin	$72000	$136000
Net Income	$32000	$32000
Operating Leverage	2.25 Times	4.25 Times

2). New Sales Volume = 8000 + 10% = 8800 units

Particulars	Cook	Penn
Sales (8800*$25)	$220000	$220000
Less : Variable Cost	(8800*$16)= $140800	(8800*$8)= $70400
Contribution Margin	$79200	$149600
Less : Fixed Cost	($40000)	($104000)
Net Income	$39200	$45600

% Change in Net Income :-

Cook = ($39200 - $32000) / $32000 = 22.5% Increase

Penn = ($45600 - $32000) / $32000 = 42.5% Increase

3) New Sales Volume = 8000 - 10% = 7200 units

Particulars	Cook	Penn
Sales (7200*$25)	$180000	$180000
Less : Variable Cost	(7200*$16)= $115200	(7200*$8)= $57600
Contribution Margin	$64800	$122400
Less : Fixed Cost	($40000)	($104000)
Net Income	$24800	$18400

% Change in Net Income :-

Cook = ($24800 - $32000) / $32000 = 22.5% Decrease

Penn = ($18400 - $32000) / $32000 = 42.5% Decrease