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A proposed project has fixed costs of $38,000 per year. The operating cash flow at 7,000 units is $88,000.

A proposed project has fixed costs of $38,000 per year. The operating cash flow a 7,000 units is $88,000. a. Ignoring the eff

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Answer #1

a. The formula for calculating operating leverage is Contribution / EBIT, but before we need to make ascertain contribution, this can be done as follows:

Sales

- Variable cost

= Contribution

- Fixed cost

= EBIT

Here, EBIT and fixed cost is given so both will be added to arrive at contribution.

Contribution = $88,000 + $38,000

                   = $126,000

So, Operating leverage = Contribution / EBIT

                                  = $1,26,000 / 88,000

                                 = 1.4318

b. The contribution of $1,26,000 on 7,000 units indicate $18/unit (Contribution / Total units sold) contribution. Hence, if there will be an increase of 500 units, the contribution will increase by $18 * 500 = $9,000, the new contribution will become $126,000 + $9,000 = $135,000, after deducting fixed cost of $38,000 which shall remain same, the operating cash flow comes at $97,000, which is a increase of 10.23% from $88,000.

c. The new degree of operating leverage can be calculated as follows:

Contribution / EBIT

= $135,000 / $97,000

= 1.3918

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