Question

company has variable costs of $34.50, total fixed costs of $21,700,000 and plans to sell its product for $45.00. In 2018 it sold 2,400,000 units of product. Required: e) what is the operating leverage in 2018; f) the production manager wants to automate production and lower variable costs by $3 per unit and spend an additional $4,500,000 fixed costs per year- is this more profitable? g) The sales manager wants to drop prices by $2.50 per unit and spend an added $500,000 on advertising, while volume increase by 275,000 units- is this more profitable?

Answer 1

Solution e:

Operating leverage = Contribution margin / Net operating income

Contribution margin = ($45 - $34.50) * 2400000 = $25,200,000

Net operating income = contribution margin - Fixed costs = $25,200,000 - $21,700,000 = $3,500,000

Operating leverage = $25,200,000 / $3,500,000 = 7.20

Solution f:

New contribution margin per unit = $45 - ($34.50 - 3) = $13.50 per unit

New operating income = (2400000*$13.50) - ($21,700,000 + $4,500,000) = $6,200,000

As net operating income is increasing, therefore this is more profitable.

Solution g:

New contribution margin per unit = $10.50 - $2.50 = $8 per unit

New fixed costs = $21,700,000 + $500,000 = $22,200,000

New sales volume = 2400000 + 275000 = 26750000 units

New operating income = (2675000*$8) - $22,200,000 = -$800,000

As net operating income is decreasing, therefore this is not profitable.