Question

Cortez Enterprises is studying the addition of a new product that would have an expected selling price of $180 and expected variable cost of $120. Anticipated demand is 9,000 units. A new salesperson must be hired because the company's current sales force is working at capacity. Two compensation plans are under consideration: Plan 1: An annual salary of $38,000 plus 10% commission based on gross sales dollars Plan 2: An annual salary of $180,000 and no commission Required: 1. What is meant by the term "operating leverage"? 2. Calculate the contribution margin and net income of the two plans at 9,000 units. 3. Compute the operating leverage factor of the two plans at 9,000 units. Which of the two plans is more highly leveraged? Why? 4. Assume that a general economic downturn occurred during year no. 2, with product demand falling from 9,000 to 7,200 units. By using the operating leverage factors, determine and show which plan would produce a larger percentage decrease in net income.

Answer 1

	Operating leverage is a measure of change in operating income corresponding to change in sales
		Plan 1	Plan 2
	Selling price per unit	180	180
	Variable cost per unit	138	120
	Contribution Margin per unit	42	60
	Fixed costs	38,000	180,000
	Number of Units	9,000	9,000
2	Total CM	378,000	540,000
	Operating Income	340,000	360,000
3	Operating leverage factor	1.11176471	1.5
	Plan 2 is highly leveraged a sthe factor is higher
4	% decline in sales	-20%
	% Decline in Income = Operating leverage factor*%decline in sales	-22.235%	-30.000%
	Plan 2 would produce a higher % decrease in net income