Question

Degree of Operating Leverage, Percent Change in Profit Ringsmith Company is considering two different processes to make its product-process 1 and process 2. Process 1 requires Ringsmith to manufacture subcomponents of the product in-house. As a result, materials are less expensive, but fixed overhead is higher. Process 2 involves purchasing all subcomponents from outside suppliers. The direct materials costs are higher, but fixed factory overhead is considerably lower. Relevant data for a sales level of 37,000 units follow: Process 1 Sales $9,546,000 3,663,000 Variable expenses Contribution margin Less total fixed expenses Operating income $5,883,000 3,736,925 Process 2 $9,546,000 5,328,000 $4,218,000 1,434,320 $2,783,680 $258 $144 $114 $2,146,075 $258 Unit selling price Unit variable cost Unit contribution margin $99 $159 Required: 1. Compute the degree of operating leverage for each process. Round your answers to one decimal place. Use the rounded answers in subsequent calculations. Process 1 Process 2 2. Suppose that sales are 20 percent higher than budgeted. By what percentage will operating income increase for each process? Process 1 Process 2

Answer 1

Solution

Ringsmith Company

1. Computation of the degree of the operating leverage for each process:

Degree of operating leverage = contribution margin/net operating income

Process 1 –

Contribution margin = $5,883,000

Operating income = $2,146,075

Degree of operating leverage = 5,883,000/2,146,075 = 2.74

DOL = 2.7 (rounded off)

Process 2 –

Contribution margin = $4,218,000

Operating income = $2,783,680

Degree of operating leverage = 4,218,000/2,783,680 = 1.52

DOL = 1.5 (rounded off)

2. Computation of increase in operating income with 20% increase in sales:

Percent increase in operating income = degree of operating leverage x percent increase in sales

Process 1 –

DOL = 2.7

Percent increase in sales = 20%

Percent increase in operating income = 2.7 x 20% = 54%

Operating income would increase by 54%.

sales (20% higher from budgeted)	$9,546,000 + 20% x 9,546,000	$11,455,200
variable expenses (decrease proportionately)	$3,663,000 + 20% x 3,663,000	$4,395,600
Contribution margin		$7,059,600
less: total fixed expenses		$3,736,925
Operating income		$3,322,675

Total operating income for Process 1 = 3,322,675 - 2,146,075 = $1,176,600

Percent increase = 1,176,600/2,146,075 = 54%

Process 2 –

DOL = 1.5

Percent increase in sales = 20%

Percent increase in operating income = 1.5 x 20% = 30%

Operating income would increase by 30%.

Total operating income for Process 2

sales (20% higher from budgeted)	$9,546,000 + 20% x 9,546,000	$11,455,200
variable expenses (increase proportionately)	$5,328,000 + 20% x 5,328,000	$6,393,600
Contribution margin		$5,061,600
less: total fixed expenses		$1,434,320
Operating income		$3,627,280

= 3,627,280 - 2,783,680 = 843,600

843,600/2,783,680 x 100 = 30%

3. Computation of change in operating income, when unit sales decrease by 10% from the budgeted level:

Process 1 –

DOL = 2.7

Percent decrease in sales = 10%

Percent change in operating income = 10% x 2.7 = -27%

Operating income would decrease by 27%.

Total operating income for Process 1 –

sales (10% lower from budgeted)	$9,546,000 - 10% x 9,546,000	$8,591,400
variable expenses (decrease proportionately)	$3,663,000 - 3,663,000 x 10%	$3,296,700
Contribution margin		$5,294,700
less: total fixed expenses		$3,736,925
Operating income		$1,557,775

Change in operating income from budgeted = 2,146,075 – 1,557,775 = $588,300

Percent decrease = 588,300/2,146,075 = 27%

Process 2 –

DOL = 1.5

Percent decrease in sales = 10%

Percent change in operating income = -10% x 1.5 = - 15%

Operating income would decrease by 15% as shown below,

sales (10% lower from budgeted)	$9,546,000 - 10% x 9,546,000	$8,591,400
variable expenses (decrease proportionately)	$5,328,000 – 10% x 5,328,000	$4,795,200
Contribution margin		$3,796,200
less: total fixed expenses		$1,434,320
Operating income		$2,361,880

Decrease in operating income = 2,783,680 – 2,361,880 = $421,800

Percent decrease = 421,800/2,783,680 = 15%

Hence, operating income decrease by 15%, when sales decrease by 10%.