Question

Two firms, A and B, both produce widgets. The price of widgets is $1 each. Firm A has total fixed costs of $500,000 and variable costs of 50¢ per widget. Firm B has total fixed costs of $240,000 and variable costs of 75¢ per widget. The corporate tax rate is 40%. If the economy is strong, each firm will sell 1,200,000 widgets. If the economy enters a recession, each firm will sell 1,100,000 widgets. Calculate firm B's degree of operating leverage.

A. .714

B. 9.09

C. 7.86

D. 7.14

Answer 1

Answer :- C. 7.86

Calculation :-

Degree of operating leverage = change in operating income / change in sales

For Firm B, EBIT is

In case of economy is strong

Sales ( 1,200,000 * 1 ) = 1,200,000

Less: Variable cost ( 1,200,000 * 0.75 ) = 900,000

Contribution = 300,000

Less : Fixed Cost = 240,000

EBIT : 60,000

Tax @ 40% : 24,000

Operating income : 36,000

In case of economy enters recession

Sales ( 1,100,000 * 1 ) = 1,100,000

Less : Variable cost ( 1,100,000 * 0.75 ) = 825,000

Contribution = 275,000

Less : Fixed cost = 240,000

EBIT : 35,000

Tax @ 40% : 14000

Operating Income : 21,000

Degree of operating leverage = [ ( 36000 - 21000 ) / 21000 ] / [ (1200000 - 1100000 ) / 1100000 ]

= [ 15000 / 21000 ] / [ 100000 / 1100000 ]

= 0.7143 / 0.0909

= 7.86