Question

Arnold Vimka is a venture capitalist facing two alternative investment opportunities. He intends to invest $1 million in a start-up firm. He is nervous, however, about future economic volatility. He asks you to analyze the following financial data for the past year’s operations of the two firms he is considering and give him some business advice.

	Company Name
	Larson				Benson
Variable cost per unit (a)	$	21.00			$	10.50
Sales revenue (8,200 units × $31.00)	$	254,200			$	254,200
Variable cost (8,200 units × a)		(172,200	)			(86,100	)
Contribution margin	$	82,000			$	168,100
Fixed cost		(24,700	)			(110,800	)
Net income	$	57,300			$	57,300

Required

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

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

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

Answer 1

Using Contribution Approach,

Operating Leverage = contribution Margin / Net income

Now, Operating Leverage

For, Larson = 82000/57300 = 1.4311

For Benson = 168100/57300 = 2.9337

If Sales is Increse 10% per year then Increse in Net Income is:

For Larson = 1.4311 *10 = 14.311%

Net Income of Larson is Increase by 14.311%.

And Net Income = 57300 + (57300*14.311%) = $65500

Net Income is Increse by $8200

Now, for Benson = 2.9337* 10 = 29.337%

Benson Net Income is Increase by 29.337%

And Net Income = 57300 +(57300*29.337) = $74110

Net Income is aincrese by $ 16810

If Sales is decrease by 10% , then decrese in Net Income :

For Larson Net Income is decrese by 14.311% (1.4311*10).

In dollar Net Income is decrese by $8200 (57300*14.311).

Now Net Income is $49100 (57300-8200)

Now for Benson Net Income is decrese by 29.337% (2.9337*10)

In dollar Net Income is decrese by $16810 (57300*29.337%)

After decrese in sales Net Income is = 57300-16810 = $40490