Question

For an organization with annual sales of $500 million, purchases of $300 million and profit of $75 million, a 15 percent reduction in the cost of purchases would result in a profit-leverage effect of:_____.
a. 10 percent (sales increase of 10 percent would be required to achieve the same percentage increase in profit).
b. 60 percent (sales increase of 60 percent would be required to achieve the same percentage increase in profit).
c. 10 percent (sales increase of 50 percent would be required to achieve the same percentage increase in profit).
d. 15 percent (sales increase of 15 percent would be required to achieve the same percentage increase in profit).

Answer 1

Answer: B. 60 percent (sales increase of 60 percent would be required to achieve the same percentage increase in profit).

Explanation:

Annual sales = $500,000,000

Purchases = $300,000,000

Revised purchases = $300,000,000 × (100% - 15%) = $300,000,000 × 85%

= $255,000,000.

Current profit = $75,000,000

Current profit percentage = $75,000,000 / $500,000,000

= 15%

Additional profit due to the reduction in the purchases = Purchases - Revised purchases

= $300,000,000 - $255,000,000

= $45,000,000

Additional sales made = $45,000,000 / 15% = $300,000,000.

Profit Leverage effect = $300,000,000 / $500,000,000 = 0.6 = 60%

Therefore,the correct option is B.