Question

8. Operating Leverage. You estimate that your cattle farm will generate SI million of profits on sales of S4 million under normal economic conditions, and that the degree of operating leverage is 7.5. What will profits be if sales tum out to be $3.5 million? What if they are 4.5 million?

Answer 1

Under normal economic conditions:

Profit = $1.0 million
Sales = $4.0 million
Degree of Operating Leverage = 7.50

Answer a.

If sales is $3.5 million

% Change in Sales = ($3.50 million - $4.0 million) / $4.0 million
% Change in Sales = -0.1250 or -12.50%

Degree of Operating Leverage = % Change in Profit / % Change in Sales
7.50 = % Change in Profit / -0.1250
% Change in Profit = -0.9375

Profit = $1.0 million * (1 - 0.9375)
Profit = $1.0 million * 0.0625
Profit = $0.0625 million

Answer b.

If sales is $4.5 million

% Change in Sales = ($4.50 million - $4.0 million) / $4.0 million
% Change in Sales = 0.1250 or 12.50%

Degree of Operating Leverage = % Change in Profit / % Change in Sales
7.50 = % Change in Profit / 0.1250
% Change in Profit = 0.9375

Profit = $1.0 million * (1 + 0.9375)
Profit = $1.0 million * 1.9375
Profit = $1.9375 million