Analyzing operating leverage
Justin Zinder is a venture capitalist facing two alternative investment opportunities. He intends to invest $1 million in a start-up firm. He is nervous, however, about future economic volatility. He asks you to analyze the following financial data for the past year’s operations of the two firms he is considering and give him some business advice.
| Company Name | |
| Ensley | Kelley |
Variable cost per unit (a) | $21.00 | $10.50 |
Sales revenue (8,000 units × $28) | $224,000 | $224,000 |
Variable cost (8,000 units × a) | (168,000) | (84,000) |
Contribution margin | 56,000 | 140,000 |
Fixed cost | (25,000) | (109,000) |
Net income | $ 31,000 | $ 31,000 |
Required
a. Use the contribution margin approach to compute the operating leverage for each firm.
b. If the economy expands in coming years, Ensley and Kelley will both enjoy a 10 percent per year increase in sales, assuming that the selling price remains unchanged. Compute the change in net income for each firm in dollar amount and in percentage. (Note: Because the number of units increases, both revenue and variable cost will increase.)
c. If the economy contracts in coming years, Ensley and Kelley will both suffer a 10 percent decrease in sales volume, assuming that the selling price remains unchanged. Compute the change in net income for each firm in dollar amount and in percentage. (Note: Because the number of units decreases, both total revenue and total variable cost will decrease.)
d. Write a memo to Justin Zinder with your analyses and advice.
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