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Chapter 2: Q5-9DQ (page 143)

Explain why operating leverage decreases as a company increases sales and shifts away from the break-even point.

Short Answer

Expert verified

When the company increases the sales above the break even point, the percentage change in operating income as a result of percentage change in unit volume diminishes. It is so because upto the break even point, company is recovering the fixed cost but when the sale is above breakeven, the fixed cost is not charged and the EBIT of the company increase. Hence, when we move to increasingly higher level of operating income, the percentage change from the higher base is likely to be less.

Step by step solution

01

Step-by-Step Solution:Step 1: Break-even point

Break even point is the point at which the total cost (fixed and variable) and the total revenue of the company are equal. It is the point at which the fixed cost of the company is fully recognized.

02

Relationship between the operating leverage and the sales above break even point

When the sales of the company are above the break even point, then the operating leverage decreases. Operating leverage is computed by dividing the contribution with the earning before interest and taxes. After the break even point when the fixed cost is completely recognized, the EBIT of the company increases at high rate due to which the operating leverage of the company decreases.

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Most popular questions from this chapter

For December 31, 20X1, the balance sheet of Baxter Corporation was as follows:

Current assets

Liabilities

Cash

\(15,000

Accounts payable

\)17,000

Accounts receivable

20,000

Notes payable

25,000

Inventory

30,000

Bonds payable

55,000

Prepaid expenses

12,500

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Total liabilities and stockholder鈥檚 equity

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Sales for 20X2 were \)245,000, and the cost of goods sold was 60 percent of sales. Selling and administrative expense was \(24,500. Depreciation expense was 8 percent of plant and equipment (gross) at the beginning of the year. Interest expense for the notes payable was 10 percent, while the interest rate on the bonds payable was 12 percent. This interest expense is based on December 31, 20X1 balances. The tax rate averaged 20 percent.

\)2,500 in preferred stock dividends were paid, and \(5,500 in dividends were paid to common stockholders. There were 10,000 shares of common stock outstanding.

During 20X2, the cash balance and prepaid expenses balances were

unchanged. Accounts receivable and inventory increased by 10 percent. A new machine was purchased on December 31, 20X2, at a cost of \)40,000. Accounts payable increased by 20 percent. Notes payable increased by \(6,500 and bonds payable decreased by \)12,500, both at the end of the year. The preferred stock, common stock, and paid-in capital in excess of par accounts did not change.

b. Prepare a statement of retained earnings for 20X2.

Explain why the statement of cash flows provides useful information that goes beyond income statement and balance sheet data.

Easter Egg and Poultry Company has \(2,000,000 in assets and \)1,400,000 of debt. It reports net income of $200,000.

c. If the firm has an asset turnover ratio of 2.5 times, what is the profit margin

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Identify whether each of the following items increases or decreases cash flow:

Increase in accounts receivable

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Increase in accrued expenses

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The Holtzman Corporation has assets of \(400,000, current liabilities of \)50,000, and long-term liabilities of \(100,000. There is \)40,000 in preferred stock outstanding; 20,000 shares of common stock have been issued.

a. Compute book value (net worth) per share.

b. If there is $22,000 in earnings available to common stockholders and

Holtzman鈥檚 stock has a P/E of 18 times earnings per share, what is the current

price of the stock?

c. What is the ratio of market value per share to book value per share?
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