Question

Atech has fixed costs of $5.4 million and profits of $2 million. Its competitor, ZTech, is roughly the same size and this year earned the same profits, $2 million. However, ZTech operates with fixed costs of $1.90 million and lower variable costs.

a. Calculate the operating leverage for each firm. (Round your answers to 2 decimal places.)

b. Which firm will likely have higher profits if the economy strengthens? ATech ZTech

Answer 1

The operating leverage (DOL) is a ratio that measures the sensitivity of a company’s operating income to its sales. This shows how a change in the company’s sales will affect its operating income.

For Atech

Contribution margin = Profit + Fixed cost

= 2 + 5.4

= $ 7.4 m

= 3.7

For ZTech

Contribution margin = Profit + Fixed cost

= 2 + 1.90

= $3.90 m

= 1.95

The DOL indicates that every 1% change in the company’s sales will change the company’s operating income by 3.7 % for Atech and 1.95 % for Ztech.

b) If the economy strengthens and sales increases, Firm Atech is likely to have more increase in profit for very % increase in sales as its operating leverage is more.