Question

Company A is a manufacturer with current sales of \(6,000,000 and a 60% contribution margin. Its fixed costs equal \)2,600,000. Company B is a consulting firm with current service revenues of \(4,500,000 and a 25% contribution margin. Its fixed costs equal \)375,000. Compute the degree of operating leverage (DOL) for each company. Identify which company benefits more from a 20% increase in sales and explain why?

Short answer

1. Degree of operating leverage:Company A: 3.6, Company B: 1.5.
2. Profit of Company A will increase at a higher rate than company B due to an increase in sales.

Step-by-step solution

Definition of Operating Leverage

Operating leverage is a metric that determines the degree of change in the business profit due to a change in the sales of the business entity.

Degree of operating leverage

Particular	Company A	Company B
Sales	$6,000,000	$4,500,000
Less: Variable cost	(2,400,000)	(3,375,000)
Contribution margin	3,600,000	1,125,000
Less: Fixed cost	(2,600,000)	(375,000)
Pre-tax income	$1,000,000	$750,000

$\begin{array}{rcl}& & \mathrm{Company}\mathrm{A}:\\ \mathrm{Degree}\mathrm{of}\mathrm{Operating}\mathrm{leverage}& =& \frac{\mathrm{Total}\mathrm{contribution}\mathrm{margin}}{\mathrm{Pre}-\mathrm{tax}\mathrm{income}}\\ & =& \frac{\$3,600,000}{\$1,000,000}\\ & =& 3.6\\ & & \\ & & \mathrm{Company}\mathrm{B}:\\ \mathrm{Degree}\mathrm{of}\mathrm{operating}\mathrm{leverage}& =& \frac{\mathrm{Total}\mathrm{contribution}\mathrm{margin}}{\mathrm{Pre}-\mathrm{tax}\mathrm{income}}\\ & =& \frac{\$1,125,000}{\$750,000}\\ & =& 1.5\end{array}$

Benefits from an increase in the sales

Company A will benefit more than company B due to an increase in sales by up to 20% because company A has a degree of operating leverage equal to 3.6, which is more than company B. It means that the profit of company A will increase to a higher degree due to an increase in sales compared to company B.