Company A is a manufacturer with sales of $6,000,000 and a 60% contribution margin. Its fixed costs equal $2,600,000. Company B is a consulting firm with 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. Which company benefits more from a 20% increase in sales

See below

Explanation:

Company A

Degree of operating leverage is computed as

= Contribution margin / Net income

Net income = Contribution margin - Fixed costs

= 60% × $6,000,000 - $2,600,000

= $3,600,000 - $2,600,000

= $1,000,000

Degree of operating leverage = $3,600,000 /$1,000,000

= 3.6

Company B

Degree of operating leverage is computed as

= Contribution margin / Net income

Net income = Contribution margin - Fixed costs

= 25% × $4,500,000 - $375,000

= $1,125,000 - $375,000

= $750,000

Degree of operating leverage = $4,500,000 / $750,000

= 6

• 20% increase in sales company A

Sales = 20% × $6,000,000 + $6,000,000 = $7,200,000

Net income = 60% × $7,200,000 - $2,600,000 = $1,720,000

Degree of operating leverage = $4,320,000 / $1,720,000 = 2.5

• 20% increase in sales company B

Sales = 20% × $4,500,000 + $4,500,000 = $5,400,000

Net income = 25% × $5,400,000 - $375,000 = $975,000

Degree of operating leverage = $1,350,000 /$975,000 = 1.38

With regards to the above, company A tends to gain more from the sales increase because its operating leverage of 2.5 is more than that of company B, whose operating leverage is 1.38

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