Question

Company A has current sales of $4,000,000 and a 45% contribution margin. Its fixed costs are $600,000. Company B is a service firm with current service revenue of $2,800,000 and a 15% contribution margin. Company B's fixed costs are $375,000. Compute the degree of operating leverage for both companies. Which company will benefit most from a 15% increase in sales? Explain why.

Answer 1

The degree of operating leverage measures the change in operating profit given a change in sales. Company A and Company B can calculate their degrees of operating leverage using different formulas. The company with the higher increase in operating profit will benefit more from a 15% increase in sales.

Step-by-step explanation:

The degree of operating leverage measures the change in operating profit given a change in sales. It is calculated by dividing the percentage change in operating profit by the percentage change in sales. For Company A, the degree of operating leverage can be calculated as: (Current Sales - Fixed Costs) / (Current Sales - Variable Costs) = ($4,000,000 - $600,000) / ($4,000,000 - ($4,000,000 * 45%)) For Company B, the degree of operating leverage can be calculated as: (Current Service Revenue - Fixed Costs) / (Current Service Revenue - Variable Costs) = ($2,800,000 - $375,000) / ($2,800,000 - ($2,800,000 * 15%)) If both companies experience a 15% increase in sales, we can calculate the new operating profit for each company using the degree of operating leverage formula. The company with the higher increase in operating profit will benefit more from the sales increase.