Question

19. Operating leverage* A project has fixed costs of $1,000 per year, depreciation charges of $500 a year, annual revenue of $6,000, and variable costs equal to two-thirds of revenues. a. If sales increase by 10%, what will be the increase in pretax profits? b. What is the degree of operating leverage of this project?

Answer 1

SOLUTION:-

Due to fixed cost in the firm, total cost increases in the diminishing order with increase in sale. Hence, profits increase at higher pace than sales. Degree of operating leverage states the relationship between sales and profits. It shows the change in profits with respect to 1% rise in sales. In the given problem, profit can be calculated as below: Particulars Amount Revenue $6000 Less: Variable cost two third of $6000 $4000 Less: Fixed cost $1000 Less: Depreciation $500 Profit before tax $500 DOL can be calculated as below: DOL 1 Fixed cost +Depreciation Profit before tax -1 $1000+ $500 $500 = 4 times It can be ascertained from the DOL that 1% change in sales will result in 4% change in profits. Therefore if sales increase by 10%, profits increase by 40%

DOL can be calculated as below. Fixed cost + Depreciation DOL = 1+" Profit before tax $1000+ $500 = 1+ $500 = 4 times It can be ascertained from the DOL that 1% change in sales will result in 4%. DOL is 4% Abbreviations: DOL: Degree of operating leverage