Question

The Sterling Tire Company’s income statement for 20X1 is as follows: STERLING TIRE COMPANY Income Statement For the Year Ended December 31, 20X1 Sales (20,000 tires at $60 each)$1,200,000 Less: Variable costs (20,000 tires at $30)600,000 Fixed costs 400,000Earnings before interest and taxes (EBIT)$ 200,000Interest expense 50,000Earnings before taxes (EBT)$ 150,000Income tax expense (30%) 45,000Earnings after taxes (EAT)$ 105,000 Given this income statement, compute the following:

a. Degree of operating leverage.
b. Degree of financial leverage.
c. Degree of combined leverage.
d. Break-even point in units.

Answer 1

The degree of operating leverage (DOL) is 3, the degree of financial leverage (DFL) is 1.33, the degree of combined leverage (DCL) is 3.99, and the break-even point in units is 13,333.

Step-by-step explanation:

The degree of operating leverage (DOL) measures the percentage change in earnings before interest and taxes (EBIT) resulting from a percentage change in sales. It can be calculated as contribution margin divided by EBIT. In this case, the contribution margin is $600,000 ($1,200,000 - $600,000) and the EBIT is $200,000. Therefore, the DOL is 3 ($600,000 / $200,000).

The degree of financial leverage (DFL) measures the percentage change in earnings before taxes (EBT) resulting from a percentage change in EBIT. It can be calculated as EBIT divided by EBT. In this case, the EBIT is $200,000 and the EBT is $150,000. Therefore, the DFL is 1.33 ($200,000 / $150,000).

The degree of combined leverage (DCL) measures the percentage change in earnings after taxes (EAT) resulting from a percentage change in sales. It can be calculated as DOL multiplied by DFL. In this case, the DOL is 3 and the DFL is 1.33. Therefore, the DCL is 3.99 (3 * 1.33).

The break-even point in units can be calculated using the formula: Break-even point (in units) = Fixed costs / Contribution margin per unit. In this case, the fixed costs are $400,000 and the contribution margin per unit is $30 ($60 - $30). Therefore, the break-even point in units is 13,333 ($400,000 / $30).