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The answer to Degree of operating leverage

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An investment banker is analyzing two companies that specialize in the production and sale of candied apples. Old-Fashion Apples uses a labor-intensive approach, and Mech-Apple uses a mechanized system. CVP income statements for the two companies are shown below. Sales- $396,100 (OFA) $396,100 (MA); Variable costs- $284,520 (OFA) $157638 (MA); Contribution margin- $111,580 (OFA) $238,462 (MA); Fixed costs- $47,820 (OFA) $174,702 (MA); Net Income- $63,760 (OFA) $63,760 (MA).

The investment banker is interested in acquiring one of these companies. However, she is concerned about the impact that each company's cost structure might have on its profitability. Calculate each company's degree of operating leverage.

Determine which company's cost structure makes it more sensitive to changes in sales volume.

Determine the effect on each company's net income if sales decrease by 13% and if sales increase by 6.7%. Do not prepare income statements.

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Solution Summary

This solution illustrates how to compute a company's degree of operating leverage and how to perform a sensitivity analysis using that information.

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The degree of operating leverage tells an analyst how sensitive a firm's changes in net income are to changes in sales. The formula is:

Degree of operating leverage = Contribution margin/Net operating Income

For Old-Fashion Apples, the degree of operating leverage is:

Degree of operating leverage ...

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