Question

Ion Generating, Inc., produces ion generators and control (detection) devices for industrial applications such as chemical labs. It is contemplating an expansion into the home security market by producing a smoke detector based off of the same technology that would sell at a price of $50. The production of each smoke detector would require $20 in materials, and 0.4 hours of labor at the rate of $25 per hour. Energy, supervisory and other variable overhead costs would amount to $10 per unit. The accounting department has derived an allocated fixed overhead charge of $7.50 per smoke detector (at a projected volume of 300,000 units) to account for the expected increase in fixed costs.

a. Calculate the degree of operating leverage at a projected volume of 300,000 units and explain what the DOL means. Then calculate the DOL at the breakeven sales level. What happens to DOL when output approaches breakeven level?

Answer 1

Income Statement for 300,000 units

Sales 50*300,000	15,000,000
Less: Variable costs
Direct Material	6,000,000
Direct Labor	3, 000,000
Other Variable	3, 000,000
Contribution	3,000,000
Less: Fixed Costs (7.5*300,000)	2,250,000
EBIT	750,000

Degree of Operating Leverage = Contribution/EBIT ie. 3,000,000/750,000 => 4.

Break Even Units => Fixed Cost/Contribution per Unit ie, 2,250,000/10 = 225,000 units.

So, Degree of Operating Leverage => Percentage Changes in EBIT/percentage Changes in Sales ie. Percentage changes in EBIT=> Since it's break even, EBIT=0. So -100%

Percrntage change in sales=> [15,000,000-(225,000*50)]/15000,000*100 = -25%

So, degree of Operating Leverage => -100%/-25% = 4

Thus operating leverage remains the same even at break even levels.