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Q24E

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Financial & Managerial Accounting
Found in: Page 838
Financial & Managerial Accounting

Financial & Managerial Accounting

Book edition 7th
Author(s) John J Wild, Ken W. Shaw, Barbara Chiappetta
Pages 1096 pages
ISBN 9781259726705

Short Answer

Company A is a manufacturer with current sales of $6,000,000 and a 60% contribution margin. Its fixed costs equal $2,600,000. Company B is a consulting firm with current service revenues of $4,500,000 and a 25% contribution margin. Its fixed costs equal $375,000. Compute the degree of operating leverage (DOL) for each company. Identify which company benefits more from a 20% increase in sales and explain why?

  1. Degree of operating leverage: Company A: 3.6, Company B: 1.5.
  2. Profit of Company A will increase at a higher rate than company B due to an increase in sales.
See the step by step solution

Step by Step Solution

Step 1: Definition of Operating Leverage

Operating leverage is a metric that determines the degree of change in the business profit due to a change in the sales of the business entity.

Step 2: Degree of operating leverage

Particular

Company A

Company B

Sales

$6,000,000

$4,500,000

Less: Variable cost

(2,400,000)

(3,375,000)

Contribution margin

3,600,000

1,125,000

Less: Fixed cost

(2,600,000)

(375,000)

Pre-tax income

$1,000,000

$750,000

Step 3: Benefits from an increase in the sales

Company A will benefit more than company B due to an increase in sales by up to 20% because company A has a degree of operating leverage equal to 3.6, which is more than company B. It means that the profit of company A will increase to a higher degree due to an increase in sales compared to company B.

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