Degree of operating leverage (DOL) is a ratio concept that gives management an i

Question

Degree of operating leverage (DOL) is a ratio concept that gives management an idea of the effect on profits of a small change in quantity assuming that price, fixed cost and average variable cost remain the same. The formula for

1. For a given price P = $5, AVC = $3 and FC = $20,000, what is the DOL if the manufacturer is producing 15000 units?

2. Using the value of DOL calculated in (a) above, calculate the profits for a 10% increase and 10% decrease in quantity.

3. From the DOL formula, you can see that a manufacturing plan with higher fixed costs and lower variable costs will have a higher DOL relative to a plant with higher variable costs and lower fixed costs i.e. a capital intensive production process will have a higher DOL than a labor intensive process which means at a faster rate (relative to quantity) than a labor intensive process. Suppose a company is currently producing 100 units of a bottled power drink priced at #5. It is using a manufacturing process with a fixed cost of $1450 and variable cost of $2.75 per unit (i.e. AVC).

a. Calculate the DOL and the break-even point for this production process. Is the company breaking even yet?

b. If the company installs updated machinery its fixed costs rise to $2000 and AVC drops to $2.25. Calculate the DOL and break-even point.

c. At what production level should the company switch from the old machinery to the upgraded one?

Explanation / Answer

Percentage change in profit = % change in quantity*DOL= 10%*3= 30%

For 10% decrease

Percentage change in profit = % change in quantity*DOL= -10%*3= -30%

a. DOL = 100*(5-2.75)/(100*(5-2.75)-1450)=-0.18

Brekeven point = 1450/(5-2.75)= 644.44 or 645 units

No the company is not breaking even

b. DOL = 100*(5-2.25)/(100*(5-2.75)-2000)=-0.15

Brekeven point = 2000/(5-2.25)= 727 units

c. Production level = 2000/(5-2.25) = 727 units

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