Modern Artifacts can produce keepsakes that will be sold for $250 each. Nondepre

Question

Modern Artifacts can produce keepsakes that will be sold for $250 each. Nondepreciation fixed costs are $3,000 per year, and variable costs are $150 per unit. The initial investment of $9,000 will be depreciated straight-line over its useful life of 9 years to a final value of zero, and the discount rate is 16%.

a. What is the degree of operating leverage of Modern Artifacts when sales are $11,250? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

b. What is the degree of operating leverage when sales are $19,500? (Do not round intermediate calculations. Round your answer to 2 decimal places.)

c. Why is operating leverage different at these two levels of sales?

Explanation / Answer

a) Degree of Operating Leverage = Q(P-V) / Q(P-V)- F

Given Sales = 11,250

Number of units sold, Q = 11,250/250 = 45

P= 250

V= 150

F= 3000+ 1000(depreciation)

DOL = 45*(250-150)/45*(250-150)-4000 = 4500/(4500-4000) = 9

b)

Q = 19,500/250 = 78

DOL = 78*100/(78*100-4000)=7800/3800 = 2.05

c)

Greater use of fixed cost relative to variable and operating costs will mean larger degree of operating leverage as company's operating income will be more sensitive to changes in in sales. In case two the fixed costs are relatively smaller than the variable costs as now more units are produced bringing down the DOL substantially.

DOL can also be defined as % change in Operating income to % change in units sold. As the units sold had shown a substantial increase from 45 to 78 (almost 75% increase) the DOL has shown a dip.

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