Question

Company A is a manufacturer with sales of $3,400,000 and a 60% contribution margin. Its fixed costs equal $1,600,000. Company B is a consulting firm with service revenues of $3,500,000 and a 25% contribution margin. Its fixed costs equal $410,000. Compute the degree of operating leverage (DOL) for each company. Which company benefits more from a 20% increase in sales.

Answer 1

DOL of Company A= 4.63

DOL of Company B=1.88

Company A benefits more from a 20% increase in sales

Step-by-step explanation:

The degree of operating leverage measures the volatility in the operating profit of a business as result of the proportion of fixed cost to its total costs.

The operating Leverage = Contribution margin/Operating income

Contribution = Contribution % × sales value

Operating income = Contribution - Fixed cost

Company A

Contribution margin= 60%× 3,400,000 = 2,040,000

Operating income = 60%× 3,400,000 - 1,600,000= 440,000

DOL =2,040,000 /440,000 = 4.634

DOL of Company A= 4.63

Company B

Contribution margin= 25%× 3,500,000=875000

Operating income = 875,000 - 410,000 =465000

DOL = 875,000 /465,000 × 100 =1.88

DOL=1.88

If both companies experience an increase of 20%, the corresponding increase in profit would be:

Company A= 4.63× 20= 92.6%

Company B = 1.88 × 20 = 37.6%

Company A benefits more

DOL of Company A= 4.63

DOL of Company B=1.88

Company A benefits more from a 20% increase in sales