Question

EA13.

LO 3.5Company A has current sales of $10,000,000 and a 45% contribution margin. Its fixed costs are $3,000,000. Company B is a service firm with current service revenue of $5,000,000 and a 20% contribution margin. Company B’s fixed costs are $500,000. Compute the degree of operating leverage for both companies. Which company will benefit most from a 25% increase in sales? Explain why.

Answer 1

Step-by-step explanation:

Company A: DOL = Contribution Margin/Operating Income

Contribution Margin = sales *45% = 10,000,000*45%= 4,500,000

Operating Income = contribution margin less fixed cost = 4,500,000-3,00,000 = 1,500,000

DOL = 4,500,000/1,500,000

= 3

Company B: DOL = Contribution Margin/Operating Income

Contribution Margin = sales *20% = 5,000,000*20%= 1,000,000

Operating Income = contribution margin less fixed cost = 1,000,000-500,000 = 500,000

DOL = 1,000,000/500,000

= 2

With an Increase in sales of 25%

Company A=DOL = Contribution Margin/Operating Income

Contribution Margin = sales *45% = 12,500,000*45%= 5,625,000

Operating Income = contribution margin less fixed cost = 5,625,000-3,00,000 = 2,625,000

DOL = 5,625,000/2,625,000

= 2.14

Company B: DOL = Contribution Margin/Operating Income

Contribution Margin = sales *20% = 6,250,000*20%= 1,250,000

Operating Income = contribution margin less fixed cost = 1,250,000-500,000 = 750,000

DOL = 1,250,000/750,000

=1.67

From the above, Company A with a 25% increase in sales will record a 50% and above increase in operating Income because its degree of operating leverage is 2.14