Question

Illinois Tool Company's (ITC) fixed operating costs are $1,260,000 and its variable cost ratio (i.e., variable costs as a fraction of sales) is 0.70. The firm has $3,000,000 in bonds outstanding at an interest rate of 8%. ITC has 30,000 shares of $5 preferred stock and 150,000 shares of common stock outstanding. ITC is in the 50% corporate income tax bracket. Forecasted sales for next year are $9 million. What is ITC's degree of OPERATING LEVERAGE at a sales level of $9 million?

Answer 1

Sales = $9,000,000
Variable Cost Ratio = 0.70
Fixed Operating Costs = $1,260,000

Variable Costs = Sales * Variable Cost Ratio
Variable Costs = $9,000,000 * 0.70
Variable Costs = $6,300,000

Contribution Margin = Sales - Variable Costs
Contribution Margin = $9,000,000 - $6,300,000
Contribution Margin = $2,700,000

Net Operating Income = Contribution Margin - Fixed Operating Costs
Net Operating Income = $2,700,000 - $1,260,000
Net Operating Income = $1,440,000

Degree of Operating Leverage = Contribution Margin / Net Operating Income
Degree of Operating Leverage = $2,700,000 / $1,440,000
Degree of Operating Leverage = 1.875