Engberg Company installs lawn sod in home yards. The company\'s most recent mont

Question

Engberg Company installs lawn sod in home yards. The company's most recent monthly contribution format income statement follows:


Amount Percent of sales

Sales $138,000 100%
Variable expenses 55,200 40%

Contribution margin 82,800 60%

Fixed expenses 21,000

Net operating income $61,800


Requirement 1:
Compute the company's degree of operating leverage. (Round your answer to 2 decimal places.)

Degree of operating leverage

Requirement 2:
Using the degree of operating leverage, estimate the impact on net operating income of a 20% increase in sales. (Round your answer to 2 decimal places, e.g., .1234 as 12.34. Omit the "%" sign in your response.)


Estimated percent change in net operating income %

Requirement 3:
Verify your estimate from requirement (2) by constructing a new contribution format income statement for the company assuming a 20% increase in sales. (Round "percent change" to 2 decimal places, e.g., .1234 as 12.34. Final answer may vary from Requirement 2 due to rounding. Input all amounts as positive values. Omit the "$" and "%" signs in your response.)


Amount

Sales $
Variable expenses
Contribution margin
Fixed expenses
Net operating income $
Original net operating income $
Percent change in net operating income %

Explanation / Answer

1) The degree of operating leverage is computed as

DOL = 1 + (FC / OCF)

Where DOL = Degree of operating leverage
             FC = Fixed costs
           OCF = Operating cash flows

OCF = (P - v) * Q - FC
where P is the price per unit
v is the variable cost per unit
Q is the number of units

OCF = (82800) - 21000
       = 61800

Therefore, DOL = 1 + (21000 / 61800)
                       = 1 + 0.3398
                       = 1.3398

Adjusting to two decimal points 133.98

2) If the sales increase by 20% then the effect on net operating income is

Sales = 138000 (1.20) = 165600
Variable expenses = 66240

Computing the degree of operating leverage

                                       DOL = 1 + FC / OCF

                                        OCF = 99360 - 21000
                                               = 78360
Therefore, with 20% increase in sales, the operating cash flows increased by 26.8%

DOL = 1+ (21000 / 78360)
= 1 + 0.268
= 1.268

Adjusting to two decimal points 12.68

The reason DOL declines is that fixed costs, considered as a percentage of operating cash flow, get smaller and smaller, so the leverage effect diminishes.

3) Contribution format income statement:

Sales 165600
(-) Varaible costs 66240
--------------------------------------
Contribution margin 99360
(-) Fixed expenses 21000
--------------------------------------
Net operating income 78360
--------------------------------------

Therefore, with 20% increase in sales, the net operating income will increase by

16560 / 61800 = 0.268 or 26.8%

With 20% increase in sales, the operating income increased by 26.8%

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