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Chapter 2: Q5-9DQ (page 143)

Explain why operating leverage decreases as a company increases sales and shifts away from the break-even point.

Short Answer

Expert verified

When the company increases the sales above the break even point, the percentage change in operating income as a result of percentage change in unit volume diminishes. It is so because upto the break even point, company is recovering the fixed cost but when the sale is above breakeven, the fixed cost is not charged and the EBIT of the company increase. Hence, when we move to increasingly higher level of operating income, the percentage change from the higher base is likely to be less.

Step by step solution

01

Step-by-Step Solution:Step 1: Break-even point

Break even point is the point at which the total cost (fixed and variable) and the total revenue of the company are equal. It is the point at which the fixed cost of the company is fully recognized.

02

Relationship between the operating leverage and the sales above break even point

When the sales of the company are above the break even point, then the operating leverage decreases. Operating leverage is computed by dividing the contribution with the earning before interest and taxes. After the break even point when the fixed cost is completely recognized, the EBIT of the company increases at high rate due to which the operating leverage of the company decreases.

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Most popular questions from this chapter

Dr. Zhivàgo Diagnostics Corp.’s income statement for 20X1 is as follows:

Sales\( 2790000
Cost of goods sold1790000
Gross Profits\)1000000
Selling and administrative expenses302000
Operating profits\(698000
Interest Expense54800
Income before taxes\)643200
Taxes30%192960
Income after-tax$ 450240

Compute the profit margin for 20X1.

Dr. Zhivàgo Diagnostics Corp.’s income statement for 20X1 is as follows

Sales\( 2790000
Cost of goods sold1790000
Gross profits\) 1000000
Selling and administrative expenses302000
Operating profits\( 698000
Interest Expense54800
Income before tax\) 643200
Taxes 30%192960
Income after tax$ 450240

b. Assume that in 20X2, sales increase by 10 percent and cost of goods sold increases by 20 percent. The firm is able to keep all other expenses the same. Assume a tax rate of 30 percent on income before taxes. What is income after taxes and the profit margin for 20X2?

Baker Oats had an asset turnover of 1.6 times per year.

a. If the return on total assets (investment) was 11.2 percent, what was Baker’sprofit margin?

Stein Books Inc. sold 1,900 finance textbooks for \(250 each to High Tuition University in 20X1. These books cost \)210 to produce. Stein Books spent \(12,200 (selling expense) to convince the university to buy its books. Depreciation expense for the year was \)15,200. In addition, Stein Books borrowed $104,000 on January 1, 20X1, on which the company paid 12 percent interest. Both the interest and principal of the loan were paid on December 31, 20X1. The publishing firm’s tax rate is 30 percent. Did Stein Books make a profit in 20X1? Please verify with an income statement.

Using the income statement for Times Mirror and Glass Co., compute the following ratios:

The total assets for this company equal \(80,000. Set up the equation for the Du Pont system of ratio analysis, and compute c, d, and e.

e. Return on assets (investment).

Times mirror and glass company

Sales

\)126,000

Less: Cost of goods sold

93,000

Gross profit

\(33,000

Less: selling and administrative expenses

11,000

Lease Expenses

4,000

Operating profit*

\)18,000

Less: Interest expenses

3,000

Earning before taxes

\(15,000

Less: Taxes (30%)

4,500

Earning after taxes

\)10,500

*equal income before interest and taxes
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