Chapter 11, Problem 27P

a)

To determine

The computation of magnitude of operating leverage utilising contribution margin approach of each firm.

Answer to Problem 27P

the operating leverage of L Company and B Company are 1.5 times and 3 times.

Explanation of Solution

Given information:

The formula to calculate the magnitudes of operating leverage are as follows:

$\text{Magnitude of operating leverage}=\frac{\text{Contribution margin}}{\text{Net income}}$

Calculate the magnitude of operating leverage of L Company and B Company:

$\begin{array}{c}\text{Magnitude of operating leverage}=\frac{\text{Contribution margin}}{\text{Net income}}\\ =\frac{\$72,000}{\$48,000}\\ =1.5\text{times}\end{array}$

$\begin{array}{c}\text{Magnitude of operating leverage}=\frac{\text{Contribution margin}}{\text{Net income}}\\ =\frac{\$144,000}{\$48,000}\\ =3\text{times}\end{array}$

Hence, the operating leverage of L Company and B Company are 1.5 times and 3 times.

b)

To determine

Determine the change in net income in amount and change in percentage of net income

Explanation of Solution

Given information:

The sales increased by 10% for both Company L and Company B and selling price remain unchanged.

The formula to calculate the percentage change in net income:

$\left(\text{Percentage change in net income}\right)=\frac{\text{Current year net income}-\text{Base year net income}}{\text{Base year net income}}$

Compute the change in net income in dollars:

Calculate the percentage change in net income of Company L and Company B:

$\begin{array}{c}\left(\begin{array}{l}\text{Percentage change in net income}\\ \left(\text{Company L}\right)\end{array}\right)=\frac{\text{Current year net income}-\text{Base year net income}}{\text{Base year net income}}\\ =\frac{\$55,200-\$48,000}{\$48,000}\\ =15\%\end{array}$

$\begin{array}{c}\left(\begin{array}{l}\text{Percentage change in net income}\\ \left(\text{Company B}\right)\end{array}\right)=\frac{\text{Current year net income}-\text{Base year net income}}{\text{Base year net income}}\\ =\frac{\$62,400-\$48,000}{\$48,000}\\ =30\%\end{array}$

Hence, the percentage change of net income of Company L and Company B is 15% and 30%

c)

To determine

Determine the change in net income in amount and change in percentage of net income.

Explanation of Solution

Given information:

The sales decreased by 10% for both Company L and Company B and selling price remain unchanged.

The formula to compute the percentage change in net income:

$\left(\text{Percentage change in net income}\right)=\frac{\text{Current year net income}-\text{Base year net income}}{\text{Base year net income}}$

Compute the change in net income in dollars:

Calculate the percentage change in net income of Company L and Company B:

$\begin{array}{c}\left(\begin{array}{l}\text{Percentage change in net income}\\ \left(\text{Company L}\right)\end{array}\right)=\frac{\text{Current year net income}-\text{Base year net income}}{\text{Base year net income}}\\ =\frac{\$40,800-\$48,000}{\$48,000}\\ =-15\%\end{array}$

$\begin{array}{c}\left(\begin{array}{l}\text{Percentage change in net income}\\ \left(\text{Company B}\right)\end{array}\right)=\frac{\text{Current year net income}-\text{Base year net income}}{\text{Base year net income}}\\ =\frac{\$33,600-\$48,000}{\$48,000}\\ =-30\%\end{array}$

Hence, the percentage change of net income of Company L and Company B is −15% and −30%

d)

To determine

Write a memo regarding the analyses and advice by Person JD.

Explanation of Solution

To,

Person A

From,

Person JD

Subject:

Analysis and recommendation regarding the investment

Date: 11/29/2018

The rewards and risk of both the companies are different even though they have same amount of sales and net income. From the analysis of Person JD the operating leverage is 1.5 for Company L and 3 for Company B.

The analytical data indicates that income of Company B is more volatile than Company L.

Investment in Company B will be the better choice in a economy boom situation. Otherwise, Company L is considering better. An aggressive investor can choice Company B and a conservative investor can go for Company L.