Question

Arnold Vimka is a venture capitalist facing two alternative investment opportunities. He intends to invest $1 million in a start-up firm. He is nervous, however, about future economic volatility. He asks you to analyze the following financial data for the past year’s operations of the two firms he is considering and give him some business advice.Company Name
Larson Benson
Variable cost per unit (a) $ 18.00 $ 9.00
Sales revenue (8,100 units × $31.00) $ 251,100 $ 251,100
Variable cost (8,100 units × a) (145,800 ) (72,900 )
Contribution margin $ 105,300 $ 178,200
Fixed cost (25,000 ) (97,900 )
Net income $ 80,300 $ 80,300
Required:
1. Use the contribution margin approach to compute the operating leverage for each firm.
2. If the economy expands in coming years, Larson and Benson will both enjoy a 11 percent per year increase in sales, assuming that the selling price remains unchanged. Compute the change in net income for each firm in dollar amount and in percentage. (Note: Since the number of units increases, both revenue and variable cost will increase.)
3. If the economy contracts in coming years, Larson and Benson will both suffer a 11 percent decrease in sales volume, assuming that the selling price remains unchanged. Compute the change in net income for each firm in dollar amount and in percentage. (Note: Since the ­number of units decreases, both total revenue and total variable cost will decrease.)

Answer 1

Answer:

Arnold Vimka

1. Operating leverage, using the contribution margin approach:

                                                             Larson          Benson

Operating leverage                                1.31                2.22

2. Change in net income for each firm in dollar amount and in percentage, following 11% increase in the units sold:

                                                                 Larson          Benson

Variable cost per unit (a)                        $ 18.00           $ 9.00

Sales revenue (8,991 units × $31.00) $278,721      $ 251,100

Variable cost (8,991 units × a)              (161,838 )        (80,919 )

Contribution margin                           $ 116,883       $ 170,181

Fixed cost                                              (25,000 )       (97,900 )

Net income                                           $ 91,883       $ 72,281

Net income                                          $ 80,300      $ 80,300

Change in net income ($)                      $11,583         ($8,019)

Change in net income (%)                    + 14.42%        -9.99%

3. Change in net income for each firm in dollar amount and in percentage, following 11% decrease in the units sold:

                                                                Larson          Benson

Variable cost per unit (a)                        $ 18.00           $ 9.00

Sales revenue (7,209 units × $31.00) $ 223,479      $ 223,479

Variable cost (7,209 units × a)               (129,762 )         (64,881 )

Contribution margin                               $ 93,717       $ 158,598

Fixed cost                                                (25,000 )        (97,900 )

Net income                                             $ 68,717        $ 60,698

Net income                                            $ 80,300       $ 80,300

Change in net income($)                       -$11,583        ($19,602)

Change in net income (%)                     -14.42%         -24.4%

Explanation:

a) Data and Calculations:

                                                                 Larson          Benson

Variable cost per unit (a)                        $ 18.00           $ 9.00

Sales revenue (8,100 units × $31.00) $ 251,100      $ 251,100

Variable cost (8,100 units × a)              (145,800 )       (72,900 )

Contribution margin                          $ 105,300      $ 178,200

Fixed cost                                              (25,000 )       (97,900 )

Net income                                         $ 80,300       $ 80,300

Contribution margin approach to computing the operating leverage:

= Contribution margin/net operating income

                                                                Larson          Benson

Contribution margin                          $ 105,300      $ 178,200

Net operating income                        $ 80,300       $ 80,300

Operating leverage                                1.31                2.22