Question

Describe how the Profit-Leverage Effect and Return-on-Asset Effect works. Suppose an organization has a $200 million revenue, purchases of $130 million, and profit of $13 million before tax.

1. How much would profit increase with a 10% purchase cost reduction? How much is the Return-On-Asset (ROA) after the 10% cost reduction if assets were $13 million? How does this affect the company's Inventory Investment?

Explain throughly and show your solutions.

Please answer #1

Answer 1

Answer : ( In millions )

1) Profit = $ 13

Return on assets = Net Income / total assets

Return on assets = 13 / 130

Return on assets = 10%

Increase in profit due to purchase price return = 130 *10% = $ 13

2) Revised profit = 13 + 13 = 26

Revised assets = 130 - 13 = 117

Revised ROA = 26 / 117

Revised ROA = 22.22%

Increase in ROA = 22.22 - 10 = 12.22 %

3) Inventory Investment is the main area to be focused to increase profits .

Company should follow EOQ method and order as per the best required policy .

The current gross profit ratio of company = (200 - 130 ) / 200 = 35% is good and willl be increased by reduction in the purchase cost by 10% .

Reduction in the purchase cost will eventually increase the profits of the company and helpos in expansion.