Question

Bedco makes high quality beds. Each bed sells for $1,000. They sold 750 beds in 2020 and 900 beds in 2019. Their costs for both years are presented below:

2019:

Cost of Goods Sold: $360,000

Operating Expenses: $220,000

Factory Rent: $60,000

2020:

Cost of Goods Sold: 300,000

Operating Expenses: 190,000

Factory Rent: 60,000

PART A: COMPUTE BEDCO’S 2020 DEGREE OF OPERATING LEVERAGE.

PART B: The president expects sales revenues to increase by 46% in 2021. Using the Degree of Operating Leverage information calculated above, please provide the following information.

Expected Percentage Increase in Net Income: ?

Expected 2021 Net Income Amount Assuming the 46% Sales Revenue Increase: ?

Answer 1

Part A

DOL = % change in EBIT / % change in sales

EBIT = revenue - COGS - operating expenses - rent

EBIT in 2019 = (900 * $1,000) - $360,000 - $220,000 - $60,000 = $260,000

EBIT in 2020 = (750 * $1,000) - $300,000 - $190,000 - $60,000 = $200,000

% change in EBIT = ($200,000 - $260,000) / $260,000 = -23.08%

% change in sales = ($750,000 - $900,000) / $900,000 = -16.67%

DOL = (-23.08%) / (-16.67%) = 1.3846, or 138.46%

Part B

Expected % increase in net income = 138.46%

Expected net income = net income in 2020 * DOL = $200,000 * 138.46% = $276,923