Question

Healthy Foods Inc. sells 50-pound bags of grapes to the military for \(10 a bag. The fixed costs of this operation are \)80,000, while the variable costs of grapes are $0.10 per pound.

c. What is the degree of operating leverage at 20,000 bags and at 25,000 bags? Why does the degree of operating leverage change as the quantity sold increases?

Short answer

The operating leverage at 20,000 bags is 5 and at 25,000 bags is 2.78.

The operating leverage changes due to increase in quantity sold because the contribution and EBIT of the company changes when the increase in sales volume.

Step-by-step solution

Income statement at the sales volume of 20,000 bags and at 25,000 bags

Particulars	20,000 bags	25,000 bags
Sales	$200,000 (20,000 x $10)	$250,000 (25,000 x $10)
Less: variable cost	100,000 (20,000 x $5)	125,000 (25,000 x $5)
Contribution	$100,000	$125,000
Less: Fixed cost	80,000	80,000
EBIT	$20,000	$45,000

Operating leverage at 20,000 bags

$\begin{array}{rcl}\mathrm{Operating}\mathrm{leverage}& =& \frac{\mathrm{Contribution}}{\mathrm{EBIT}}\\ & =& \frac{\$100,000}{\$20,000}\\ & =& 5\end{array}$

Operating leverage at 25,000 bags

$\begin{array}{rcl}\mathrm{Operating}\mathrm{leverage}& =& \frac{\mathrm{Contribution}}{\mathrm{EBIT}}\\ & =& \frac{\$125,000}{\$45,000}\\ & =& 2.78\end{array}$

Operating leverage decreases because the EBIT of the company increases with high rate in comparison of contribution.