Question

Refer to the information in Exercise 18-16.

1. Compute the company’s degree of operating leverage for 2017.

2. If sales decrease by 5% in 2018, what will be the company’s pretax income?

3. Assume sales for 2018 decrease by 5%. Prepare a contribution margin income statement for 2018.

Short answer

1. Degree of operating leverage:4.
2. Pre-tax income after a decrease in sales:$86,400.
3. The Contribution margin after a decrease in sales is$410,400.

Step-by-step solution

Definition of Contribution Margin

The sales revenue remaining for covering the fixed cost incurred by the business entity is known as the contribution margin. It is determined by the difference between the sales revenue and variable cost.

Degree of operating leverage

$\begin{array}{rcl}\mathrm{Degree}\mathrm{of}\mathrm{operating}\mathrm{leverage}& =& \frac{\mathrm{Total}\mathrm{contribution}\mathrm{margin}}{\mathrm{Pre}-\mathrm{tax}\mathrm{income}}\\ & =& \frac{\$432,000}{\$108,000}\\ & =& 4\end{array}$

Pre-tax income after a decrease in the sales by 5%

$\begin{array}{rcl}\mathrm{Pre}-\mathrm{tax}\mathrm{income}& =& \left[\mathrm{Contribution}\mathrm{margin}\times \left(100\%-5\%\right)\right]-\mathrm{Fixed}\mathrm{cost}\\ & =& \left[\$432,000\times \times 95\%\right]-\$324,000\\ & =& \$86,400\end{array}$

Contribution margin income statement after a decrease in sales

Particular	Amount $
Sales @95% of actual sales	$2,052,000
Less: Variable cost @ 95% of actual cost	(1,641,600)
Contribution margin	410,400
Less: Fixed cost	(324,000)
Pre-tax income	$86,400