Question

The pretax operating cash flow of Sandhill Motors declined so much during the recession of 2008 and 2009 that the company almost defaulted on its debt. The owner of the company wants to change the cost structure of his business so that this does not happen again. He has been able to reduce fixed costs from $489,000 to $304,000 and, in doing so, reduce the Cash Flow DOL for Sandhill Motors from 3.1 to 2.4 with sales of $1,070,000 and pretax operating cash flow of $230,000. If sales declined by 30 percent from this level, how much more pretax operating cash flow would Sandhill Motors have with the new cost structure than under the old? (Round answer to nearest whole dollar, e.g. 5,275.

Answer 1

Degree of Operating Leverage measures the % change in operating cash flow with change in sales. This is due to level of fixed costs which does not change with change is sales

At the time of growing sales, higher DOL is beneficial as the firm would earn higher operating cash flows. However at the time of reducing sales, lower DOL is beneficial.  

In the given question, DOL was reduced from 3.1 to 2.4 ( Reduced by 0.70). If sales reduce by 30% (From 1070000 to 749000), what will be the net impact on operating cash profitability due to change in fixed cost structure.

More Pre Tax Operating Cash flow earned due to new structure = Reduction in Profit under old structure - Reduction in Profit under new structure

= 230000 (30%* 3.1) - 230000 (30%*2.1)

= 213900 - 144900

= 69000