Question

What is operating leverage, and how does it affect a firm's business      risk?

                  a.   Show the operating break-even point if a company has fixed costs of $22,000, a sales price of $36, and variables costs of $14.

                  b.   What is the break-even quantity if the price is decreased to $30?

                  c.   What is the break-even point if the price is decreased to $30 and costs increase to $19?

Answer 1

Solution Operating leverage is the ratio by which a firm can increase operating income by increasing revenue. When a firm having high gross margin, have high operating leverage which do result in higher risk, as small error could lead to magnified change in operating income. Part a: Operating Break even :- fixed costs of $22,000, a sales price of $36, and variables costs of $14. FIGURE $36 $14 PARTICULARS Sales Price Less: Variable Cost Contribution per unit Fixed Cost Operating Break Even (Fixed Cost / Contribution per unit) $22 $22,000 1000 units Hence, operating breakeven is 1000 units. Part b: Operating Break even :- price is decreased to $30 PARTICULARS Sales Price Less: Variable Cost Contribution per unit Fixed Cost Operating Break Even (Fixed Cost / Contribution per unit) FIGURE $30 $14 $16 $22,000 1375 units Hence, operating breakeven is 1375 units. Part c: Operating Break even :- price is decreased to $30 and costs increase to $19 PARTICULARS Sales Price Less: Variable Cost Contribution per unit Fixed Cost Operating Break Even (Fixed Cost / Contribution per unit) FIGURE $30 $19 $11 $22,000 2000 units Hence, operating breakeven is 2000 units.