Question

Bernard Windows is a small company that installs windows. Its cost structure is as follows:

Selling price from each window installation $ 500

Variable cost of each window installation $ 400

Annual fixed costs $150,000

Number of window units sold 2,500

Bernard is considering changing its sales compensation for next year. Bernard would pay salespeople a 5% commission next year and reduce fixed selling costs by $62,500.

Calculate the degree of operating leverage at sales of 2,500 units under the two options. Comment briefly on the result.

Can someone help me with this question? Show your work calculations please! thanks in advance!

Answer 1

SOLUTION

Degree of operating leverage = Contribution margin / Operating income

S.No.	Particulars	Option 1 (No Commission)	Option 2 (5% Commission)
1	Selling price	500	500
2	Variable cost [$400, ($400+0.05*$500)]	400	425
3	Contribution margin per unit [1-2]	100	75
4	Contribution margin (Row 3*2,500)	250,000	187,500
5	Fixed Cost [150,000, (150,000-62,500)]	150,000	87,500
6	Operating income	100,000	100,000
7	Degree of operating leverage [4/6]	2.50	1.875

The result indicates that when sales are 2,500 units, a 1% change in sales and contribution margin will result in 2.5% change in operating income for option 1.

For option 2, a 1% change in sales and contribution margin will result in only 1.875% change in operating income. The degree of operating leverage at a given level of sales helps manager to calculate effect of sales fluctuations on operating income.