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Operating Leverage and Fluctuations in operating earnings

Jason Kidwell is able to purchase Toys'n Things, Inc. for $2.2 million. Jason estimates that after initiating his changes in the company's operations the firm's cost of goods sold are 55% of firm revenues and operating expenses are equal to a fixed compnonent of $350,000 plus a variable cost component equal to 10% of revenues.

a) Under the above circumstances, estimate the firm's net operating income for revenue levels $1 million, $2 million, and $4 million. What is the percentage in operating income if revenues change from $2 million to $1 million?

b) Assume that Jason is able to modify the firm's cost structure such that the fixed component of oerpating expenses declines to $50,000 per year, but the variable cost rises to 30% of firm revenues. Answer part a above under this revised cost structure. WHich of the two cost structures genertes the highest level of operating leverage? What should be the effect of the change in cost structure on the firm's equity beta?

Solution Preview

A)
At $1 million At $2 million At $4 million
Sales 1000000 2000000 4000000
Less Variable cost of goods sold 550000 1100000 2200000
Less Other Variable cost 100000 200000 400000
Contribution 350000 700000 1400000
Less Fixed cost 350000 350000 350000
Operating Income 0 350000 1050000
Operating ...

Solution Summary

Response discusses the operating Leverage and fluctuations in operating earnings

$2.19