(c) From the DOL formula, you can see that a manufacturing plant with higher fixed costs and lower variable costs will have a higher DOL relative to a plant with higher variable costs and lower fixed costs i.e. a capital intensive production process will have a higher DOL than a labor intensive process which means that a capital intensive production process will increase profits at a faster rate (relative to quantity) than a labor intensive process. Suppose a company is currently producing 1000 units of a bottled power drink priced at $5. It is using a manufacturing process with a fixed cost of $1450 and variable cost of $2.75 per unit (i.e. AVC).
i. Calculate the DOL and the break even point for this produc- tion process. Is the company breaking even yet?
BE= Fixed Costs
Price- Variable Cost Per Unit
$5- 2.75 = 644.44
ii. If the company installs updated machinery its fixed costs rise to $2000 and AVC drops to $2.25. Calculate the DOL and break even point.
iii. At what production level should the company switch from the old machinery to the upgraded one?
Solution depicts the steps to calculate BEP and DOL in the given cases.
Break-even point and degree of leverage
Healthy Foods, Inc., sells 50-pound bags of grapes to the military for $10 a bag. The fixed costs of this operation are $80,000, while the variable costs of the grapes are $.10 per pound.
a. What is the break-even point in bags?
b. Calculate the profit or loss on 12,000 bags and on 25,000 bags.
c. What is the degree of operating leverage at 20,000 bags and at 25,000 bags? Why does the degree of operating leverage change as the quantity sold increases?
d. If Healthy Foods has an annual interest expense of $10,000, calculate the degree of financial leverage at both 20,000 and 25,000 bags.
e. What is the degree of combined leverage at both sales levels?