Question

You estimate that your sheep farm will generate $0.9 million of profits on sales of $10 million under normal economic conditions and that the degree of operating leverage is 2. What will sales be if profits turn out to be $0.5 million?

Answer 1

The answer is $7.778 million. Details follows -

Here we will calculate first the percentage change in profit, which is $.5M/$.9M = .4444

Now since we need to calculate the sales on revised profit levels, to achieve the degree of operating leverage of 2, we need to do this by trial and error method to calculate the revised sales to have the DOL of 2. So if we reduce the sales by 22% i.e. $7.778 we will have the change in sales level by 22%.

Now the formula for DOL is = % change in profit / % change in sales.

Here with this above formula we calculate as follows - .44/.22 = 2 DOL.

Do let me know if you have concerns in this. Thanks