11. Cleats\' income statement for 20X1 is as follows: CLEATS, INC Income Stateme

Question

11. Cleats' income statement for 20X1 is as follows: CLEATS, INC Income Statement For the Year Ended December 31, 20X1 $7,500,000 3,300,000 750,000 3,450,000 862,500 $2,587,000 853,875 $1,733,625 Sales (50,000 units at $150 each).. Less: Variable costs (50,000 units at $66)... Fixed costs.. Earnings before interest and taxes (EBIT. Interest expense. Earnings before taxes (EB. Income tax expense (33%). Given this income statement, compute the following: a. Degrce of operating leverage(3pts) b. Degree of financial leverage (3pts). c. Degree of combined leverage (3pts). d. Break-even point in units (3pts).

Explanation / Answer

A.DEGREE OF OPERATING LEVERAGE

Operating leverage measures a company’s fixed costs as a percentage of its total costs. To calculate operating leverage, divide an entity’s contribution margin by its earning before interest and tax.(EBIT) . The contribution margin is sales minus variable expenses.

Contribution=sales –variable cost

                  =7500000-3300000

                 =4200000

EBIT=3450000

DOL=CONTRIBUTION/EBIT

          =4200000/3450000=1. 21739

DOL=1.21739 TIMES

B.DEGREE OF FINANCIAL LEVERAGE

Degree of financial leverage (DFL) is a metric that measures the sensitivity of aCompany’s operating income due to changes in its capital structure. The DFL calculation focuses on EBIT with and without interest. This formula is:

DFL = EBIT/ (EBIT-Interest)

DFL is best used to help a company determine an appropriate amount of debt, and how that debt will affect its operating income. The higher the DFL, the higher the financial risk.

DFL=EBIT/EBT

HERE EBIT =EARNING BEFORE INTREST AND TAX

EBT =EARNING AFTER TAX

EBIT=3450000

EBT=2587000

DFL=3450000/2587000=1.33359 TIMES

C.DEGREE OF COMBINED LEVERAGE (CL)

CL=DOL×DFL= CONTRIBUTION/EBIT× EBIT/EBT

               =CONTRIBUTION/EBT

             =4200000/2587000=1.62350 TIMES

DCL=1.62350

D.BEP IN UNITS

Break-even is the point of zero loss or profit. At break-even point, the revenues of the business are equal its total costs and its contribution margin equals its total fixed costs.

Break-Even Point in Units = Fixed Costs / (Price of Product - Variable Costs)

FIXED COST=750000

SELLING PRICE=$150

VARIABLE COST=$66  

BEP (IN UNITS) =750000/(150-66)

BEP (IN UNITS) =8928.5714285 UNITS

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