Question

HighTech Inc. and OldTime Co. compete within the same industry and had the following operating results in 2019:

	HighTech Inc.				OldTime Co.
Sales	$	2,300,000			$	2,300,000
Variable expenses		460,000				1,380,000
Contribution margin	$	1,840,000			$	920,000
Fixed expenses		1,570,000				650,000
Operating income	$	270,000			$	270,000

Required:

1. Calculate the breakeven point for each firm in terms of revenue.
2. What observations can you draw by examining the breakeven point of each firm given that they earned an equal amount of operating income on identical sales volumes in 2019?
3. Calculate the amount of operating income (or loss) that you would expect each firm to report in 2020 if sales were to

1. Increase by 20%.
2. Decrease by 20%.

4. Using the amounts computed in requirement c, calculate the increase or decrease in the amount of operating income expected in 2020 from the amount reported in 2019.
5. Explain why an equal percentage increase (or decrease) in sales for each firm would have such differing effects on operating income.
6. Calculate the ratio of contribution margin to operating income for each firm in 2019.
7. Multiply the expected increase in sales of 20% for 2020 by the ratio of contribution margin to operating income for 2019 computed in requirement f for each firm.
8. Multiply your answer in requirement g by the operating income of $270,000 reported in 2019 for each firm.
9. Compare your answer in requirement h with your answer in requirement d. What conclusions can you draw about the effects of operating leverage from the steps you performed in requirements f, g, and h?

Answer 1

HighTech Inc. and Oldtime Co. Requirement 1 Calculate the contribution margin ratio for each firm: HighTech, Inc Sales 2300000 Variable Expense 460000 Contribution margin 1840000 Fixed expenses 1570000 Operating income 270000 100.00% 20.00% 80.00% OldTime Co 2300000 1380000 920000 650000 270000 100.00% 60.00% 40.00% Calculate the break-even point in sales dollars for each firm: Break-even sales revenue = Fixed costs / contribution margin ratio HighTech, Inc.: Break-even sales revenue = $1,570,000 / 0.80 = $1,962,500 OldTime Co.: Break-even sales revenue = $650,000 / 0.40 = $1,625,000 Requirement 2 The break-even point for each firm is different because each firm has a different amount of fixed costs to be recovered and a different contribution margin ratio that represents the rate at which fixed costs are being recovered for each dollar of sales revenue. While the current sales of $2,300,000 happens to produce an equal amount of operating income ($270,000) in each firm, the relationship of fixed and variable costs in each firm determine its break-even point. Requirement 3 Increase in Sales by 20% Sales Variable Expense Contribution margin Fixed expenses Operating income HighTech, Inc 2760000 552000 2208000 1570000 638000 OldTime Co 2760000 1656000 1104000 650000 454000 Decrease in Sales by 20% HighTech, Inc Sales 1840000 Variable Expense 368000 Contribution margin 1472000 Fixed expenses 1570000 Operating income -98000 OldTime Co 1840000 1104000 736000 650000 86000

Requirement 4 HighTech, Inc OldTime Co Operating income reported in 2019 270000 270000 Expected operating income with 20% sales increase 638000 454000 Expected increase in operating income 368000 184000 HighTech, Inc OldTime Co Operating income reported in 2019 270000 270000 Expected operating income with 20% sales decrease -98000 86000 Expected increase in operating income 368000 184000 Requirement 5 HighTech, Inc. has significantly more operating leverage than does OldTime Co. because HighTech's fixed costs are much higher ($1,570,000 versus $650,000) and its contribution margin ratio is also much higher (80% versus 40%). Thus, if sales increase/decrease by 20% in 2019, HighTech, Inc. will benefit/suffer proportionately more than OldTime Co. because Oldtime's cost structure is riskier. Requirement 6 Contribution margin / operating income: HighTech, Inc.: $1,840,000 / $270,000 = 6.81 times OldTime Co.: $920,000 / $270,000 = 3.4 times Requirement 7 Expected increase in sales x (contribution margin / operating income): HighTech, Inc.: 20% x 6.81 = 136.2% OldTime Co.: 20% x 3.4 = 68% Requirement 8 Results from (7) above x amount of 2019 operating income HighTech, Inc.: 136.2% x $270,000 = $368,000 OldTime Co.: 68% $270,000 = $184,000 Requirement 9 The answer calculated in requirement (8) is equal to the answer calculated in requirement (d). The important point is that an expected change in operating income can be computed given a percentage change in sales by knowing each firm's degree of operating leverage. The degree of operating leverage is calculated by dividing a firm's total contribution margin by its operating income. The degree of operating leverage is then used to determine how much operating income will change for a given percentage change in sales as illustrated in requirement (6), (7), and (8). The comparative degree of operating leverage between HighTech Inc. and OldTime Co. illustrates how the relationship of fixed costs to variable costs in a firm's cost structure effects the speed at which operating income increases or decreases as sales volume changes