1. Answer the following questions: (5 points) Compute the profit leverage effect

Question

1. Answer the following questions: (5 points) Compute the profit leverage effect "for an organization with revenue of $100 million, purchases of $60 million, and profit of $8 million before tax, a 10 percent reduction in purchase spend would result in: a. How much increase/decrease in profit, please mention the dollar value as well as percentage? Assuming the same percentage hold, how much should the value of revenue/sale increase if the profit increase of $5 million were to be possible just via sales? i. ii. ii. Which of the two would you prefer, decrease of supply cost or increase of sales, explain.

Explanation / Answer

i) A 10 percent reduction in purchase spend will increase the Profit before tax by 60*10% = $ 6 m

New profit before tax = 8+6 = $ 14 m

Increase in profit = $ 6 m

Percent increase in profit = 6/8 = 75 %

b) Profit before tax as percent of sales = 8/100 = 8 %

We need a profit increase of $ 5 m

Therefore, Value of sales increase required = 5/8% = $ 62.5 m

So sales should be 100+62.5 = $ 162.5 to have a profit of $ 5 m before tax

c) We would prefer decrease in supply cost, which is a lower quantum, as compared to increase in sales, which is a very high as compared to supply cost.

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