Question

Company C is analyzing a new type of insulation for interior walls. Management has compiled the following information to determine whether or not this new insulation should be manufactured. The insulation project has an initial fixed asset requirement of $1.5 million, which would be depreciated straight-line to zero over the 10-year life of the project. Projected fixed costs are $889,000 and the anticipated annual operating cash flow is $340,000. What is the degree of operating leverage for this project? Show your work.

Answer 1

Projected Fixed Costs = $889,000

Depreciation = $15, 00,000/10= $1, 50,000

Annual Operating Cash Flow = $3, 40,000

Annual Operating Cash Flow = Net Income + Depreciation

So, Net Income = Annual Operating Cash Flow – Depreciation

Or, Net Income = $3, 40,000 - $1, 50, 000 = $1, 90, 000

Contribution = Fixed Costs + Profit (net income)

Or, Contribution = $889, 000 + $190,000 = $10, 79, 000

Degree of Operating Leverage = Contribution Margin/ Operating Margin

Operating Margin = Net Income + Depreciation + Fixed Costs

Or, Operating Margin = $190, 000 + $150, 000 + $889, 000

Operating Margin = $12, 29,000

So, Degree of Operating Leverage = $10, 79, 000/ $12, 29, 000 = 0.88