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Effects on Degree of Operating Leverage

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Degree of operating leverage measures the sensitivity of operating income earnings before income and taxes (EBIT) to changes in unit sales. With this in mind, what would happen to the DOL if all costs are fixed? Variable?

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Fixed costs are those which remain stable throughout the operational cycle. Variable costs are those which will vary in relation to sales performance. For example, fixed costs relate to rent, utilities, salaries, insurance, and the like. Variable costs relate to cost of goods sold, commissions, transportation, advertising, and so on.

Essentially then, if sales were to increase, the degree of operating leverage (DOL) would increase because all costs would have stabilized. If Sales are currently $1 million, with fixed costs of $500,000, then we have EBIT of $500,000, or a 2:1 ratio (for every dollar of sales incurred, there will be 50 cents in EBIT). Now if sales increase to $2 million, with the same fixed costs, then the ratio is 1.33:1 (creating a situation wherein for every dollar of sales, there will be a corresponding EBIT of $.33). The result is that while EBIT will increase, the DOL will increase due to the incremental change in DOL, which results in gaining EBIT due to the fixed nature of the cost structure noted as the following:

DOL = % change in EBIT/%change in Sales

Now if the same situation were to apply to variable costs, then we would notice a shift in the relationship because we now have a varying degree of costs versus sales --- as sales increase, so do costs. The result would be a decrease in operating leverage due to the fact that EBIT would reduce in value, leading to a reduction in operating leverage due to the higher cost structure as it relates to the increase in sales.

It can be seen as follows:

Fixed ...

Solution Summary

An illustration of how fixed and variable costs affect the break even point and the degree of operating leverage for a business.

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Degree of Operating Leverage

Degree of Operating Leverage. Untouchable Package Service (UPS) offers overnight package delivery to Canadian business customers. UPS has recently decided to expand its facilities to better satisfy current and projected demand. Current colume totals two million packages per week at a price of $12 each, and average variable costs are constant at all output levels. Fixed costs are $3 million per week, and profit contribution averages one-third of revenues on each delivery. After completion of the expansion project, fixed costs will double, but variable costs will decline by 25%.
A. Calculate the change in UPSâ??s weekly breakeven output level that is due to expansion.
B. Assuming that volume remains at two million packages per week, calculate the change in the degree of operating leverage that is due to expansion.
C. Again, assuming that volume remains at two million packages per week, what is the effect of expansion on weekly profit?
D. Define economies of scale. How does this relate to returns to scale? Cite and briefly discuss the main determinants of economies of scale.

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