If a firm sustains the same level of operations in terms of sales and administrative expenses,...
If a firm sustains the same level of operations in terms of sales and administrative expenses, but reduces its materials cost by $65,000 through smarter purchases, what is the profit-leverage effect on profits before taxes expressed as a dollar value?
Homework Answers
The profit-leverage effect implies the impact of purchasing cost savings to the sales equivalent required to have the same profit impact. This means that a dollar saved in purchasing almost always has a greater impact on profit than a dollar increase in sales. Hence, it is often easier to achieve profit improvement through purchasing cost reductions than equivalent sales increases.
In terms of financial impact, every dollar saved in purchasing lowers COGS (Cost of Goods Sold) by $1 will increase the pre-tax profit by $1.
In the problem given, the material cost is reduced by $65,00 through smaller purchases. This will reduce COGS by $65,000. As per profit leverage effect there will be equivalent increase of amount $65,000 in the pre-tax profits.
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