Question

The following CVP income statements are available for Blanc Company and Noir Company Blanc Company Sales Variable costs Contribution margin Fixed costs Net Income $500,000 280,000 220,000 170,000 $50,000 Noir Company $500,000 180,000 320,000 270,000 $50,000 Contribution Margin Ratio Blanc Company Noir Company 0.64 Blanc Company Noir Company Break-even Point S386,364 $421,875 Margin of Safety Ratio 0.227 0.156 Blanc Company Noir Company Degree of Operating Leverage Blanc Company Noir Company CVP income statement assuming that sales revenue increases by 20%: Sales Variable costs Contribution margin Fixed costs Net Income / (Loss) Blanc Company Noir Company $600,000 $600,000 336,000 216,000 264,000 384,000 170,000 270,000 $94,000 $114,000 CVP income statement assuming that sales revenue decreases by 20: Sales Variable costs Contribution margin Fixed costs Net Income (Loss) Blanc Company Noir Company $400,000 $400,000 224,000 144,000 176,000 256.000 170,000 270,000 $6,000 ($14,000)

Discuss how changes in sales volumes impacts the profits of each company.

Discuss how the cost structure of these two companies affects their operating leverage and profitability.

Answer 1

1. The impact of Sales Volume to profit of the company can be seen by "Degree of Operating Leverage". For example, the sales of Blanc Company has increased from $500,000 to $600,000 (20% hike) and the degree of operating leverage is 4.4, the profit will also be increased by % change in sales multiplier of degree of operating leverage i.e., 20*4.4 =88%. The profit has increased by 88% of current profit of $50,000 (revised profit = $50,000 + 88% of 50,000). Similarly, if sales decreased by 20%, profit will decrease by 20*4.4 =88%.

The same concept applies to the numbers of Noir Company.

2. A high degree of operating leverage gives an indication that a company has a high proportion of fixed operating costs compared to its variable operating costs. Degree of Operating leverage is computed by dividing Contribution margin to profit. On numerator side, Contribution margin is a result of Sales minus Variable costs and on denominator Side, Profit is a result of Contribution margin minus fixed costs. So if, Fixed cost is increased, profit will decrease and as a result, higher degree of operating leverage will be.