Question

OceanGate sells external hard drives for $200 each. Its total fixed costs are $30 million, and its variable costs per unit are $140. The corporate tax rate is 30%. If the economy is strong, the firm will sell 2 million drives, but if there is a recession, it will sell only half as many.

a. What will be the percentage decline in sales if the economy enters a recession?

b. What will be the percentage decline in profits if the economy enters a recession?

c. Comparing your answers to (a) and (b), What is the firm’s degree of operating leverage?

Answer 1

a

50%

b

	Particulars	Normal	Recession	Change
a	Sales	400,000,000	200,000,000	200,000,000
	Less: variable costs	(280,000,000)	(140,000,000)
	Less: fixed costs	(30,000,000)	(30,000,000)
	Profit before tax	90,000,000	30,000,000
	Less: taxes	(27,000,000)	(9,000,000)
b	Operating income	63,000,000	21,000,000	42,000,000

Decline in profits = 66.6667%

c

DOL = 66.6667% / 50%= 1.33