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a)
Compute the magnitude of operating leverage utilizing contribution margin approach for each firm.
a)
Answer to Problem 27P
The operating leverage of Company W and Company L are 1.5 times and 2.83 times.
Explanation of Solution
Operating leverage: It is a ratio that measures the proportion of fixed cost on the total costs and the extent to which the changes in the sales volume affects the income from operations. It shows the relationship between the contribution margin and income from operations.
Calculate the magnitude of operating leverage of Company W and Company L:
Hence, the operating leverage of Company W and Company L are 1.5 times and 2.83 times.
b)
Compute the change in net income in amount and change in percentage of net income.
b)
Explanation of Solution
Given information: The sales have increased by 10% for both Company W and Company L and the selling price remains unchanged.
The formula to calculate the percentage change in net income:
Compute the change in net income in dollars:
| Company Name | W | L |
| Variable cost per unit (a) | $ 16 | $ 8 |
| Sales revenue | $ 220,000 | $ 220,000 |
| Variable cost | ($ 140,800) | ($ 70,400) |
| Contribution margin | $ 79,200 | $ 149,600 |
| Fixed cost | ($24,000) | ($88,000) |
| Net income | $55,200 | $61,600 |
| Percentage change | 15% | 28.33% |
Table (1)
Calculate the percentage change in net income of Company W and Company L:
Hence, the percentage change of net income of Company W and Company L is 15% and 28.33%.
c)
Compute the change in net income in amount and change in percentage of net income.
c)
Explanation of Solution
Given information: The sales have decreased by 10% for both Company W and Company L and the selling price remains unchanged.
The formula to compute the percentage change in net income:
Compute the change in net income in dollars:
| Company Name | Wood | Lake |
| Variable cost per unit (a) | $16.00 | $8.00 |
| Sales revenue | $180,000 | $180,000 |
| Variable cost | (115,200) | (57,600) |
| Contribution margin | 64,800 | 122,400 |
| Fixed cost | (24,000) | (88,000) |
| Net income | $40,800 | $34,400 |
| Percentage change | (15%) | (28.33%) |
Table (2)
Calculate the percentage change in net income of Company W and Company L:
Hence, the percentage change of net income of Company W and Company L is (15%) and (28.33%).
d)
Write a memo regarding the analyses and advice to Person PS.
d)
Explanation of Solution
To,
Person PS
From,
Person A
Subject: Analysis and recommendation regarding the investment
The rewards and risk of both the companies are different even though they have same amount of sales and net income. From the above analysis the operating leverage is 1.5 for Company W and 2.83 for Company L.
The analytical data indicates that income of Company L is more volatile than Company W.
Investment in Company L will be the better choice in an economy boom situation. Otherwise, Company W is considering better. An aggressive investor can choice Company L and a conservative investor can go for Company W.
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Chapter 11 Solutions
Survey Of Accounting
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