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Leverage: Analysis of Operating Change

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Consolidated Industries is studying the addition of a new valve to its product line. The valve would be used by manufacturers of irrigation equipment. The company anticipates starting with a relatively low sales volume and then boosting demand over the next several years. A new salesperson must be hired because Consolidated's current sales force is working at capacity. Two compensation plans are under consideration.

Plan A: An annual salary of $22,000 plus a 10% commission based on gross dollar sales.

Plan B: An annual salary of $66,000 and no commission.

Consolidated Industries will purchase the valve for $50 and sell it for $80. Anticipated demand the first year is 6,000 units. (Ignore income tax)

1. Compute the break even point for plan A and B.

2. What does operating leverage mean?

3. Analyze the costs structures of both plans at the anticipated demand of 6,000 units. Which of the two plans has a higher operating leverage factor?

4. Assume that a general economic downturn occurred during year 2, with product demand falling from 6,000 to 5,000 units. Determine the percentage decrease in company net income if Consolidated had adopted Plan A.

5. Repeat question 4 but substitute for Plan B. Compare the results and explain a major factor that underlies any resulting differences.

6. Briefly discuss the likely profitability impact of an economic recession for highly automated manufacturers. What can you say about the risks associated with these firms?

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Solution Summary

The solution provides an analysis for operating change.

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1) Plan A:
Selling Price =$80
variable Cost = $50+10%*80=$58
Contribution Margin = $80-$58=$22
Fixed Cost = $22,000
BEP=FC/CM=22000/22=1000 units

Plan B:
Selling Price =$80
variable Cost = $50
Contribution Margin = $80-$50=$30
Fixed Cost = $66,000
BEP=FC/CM=66000/30=2200 units

2) Operating leverage is percentage change in operating income for 1% change in sales at a given sales ...

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