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COSTRAM - Topic 2 Assignment #4

The document summarizes financial information for Blue and Red Companies in 2019. It shows that both companies had the same net income of P500,000 despite different sales, costs, and contribution margins. Blue Company has a higher degree of operating leverage compared to Red Company, meaning its net income is more sensitive to changes in sales. If sales increase 20% for both companies, their net income will be different, with Blue earning more, because its fixed costs remain the same while contribution margin increases more due to its higher operating leverage.

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380 views

COSTRAM - Topic 2 Assignment #4

The document summarizes financial information for Blue and Red Companies in 2019. It shows that both companies had the same net income of P500,000 despite different sales, costs, and contribution margins. Blue Company has a higher degree of operating leverage compared to Red Company, meaning its net income is more sensitive to changes in sales. If sales increase 20% for both companies, their net income will be different, with Blue earning more, because its fixed costs remain the same while contribution margin increases more due to its higher operating leverage.

Uploaded by

Gray Javier
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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The following information is available for the Blue and Red Companies for 2019.

  Blue   Red
Sales (200,000 units) P1,800,000   P1,800,000
Variable costs      800,000     1,200,000
Contribution margin   1,000,000         600,000
Fixed costs      500,000        100,000
Net income P   500,000   P   500,000

Required:

A. Compute the operating leverage for each company and explain what operating
leverage measures.  (5 pts.)

Blue Company
Degree of Operating Leverage= Contribution Margin / Net Income
DOL= 1,000,000 / 500,000
DOL= 2

Red Company
Degree of Operating Leverage= Contribution Margin / Net Income
DOL= 600,000 / 500,000
DOL= 1.2

Operating leverage measures the extent on how the fixed costs are used
for the operation of the business. It tells that higher fixed cost is an indication of a
highly leveraged company. Based also to the computations above, it can
measure the sensitivity of a company’s net income to the changes in sales.
Meaning to say, the company who has a higher operating leverage, such as the
Blue company, will be most likely to have their net income sensitive to the
changes in the percentage of sales.

B. If both companies experience a 20% increase in sales volume, will they continue
to have the same net income? Why or why not? Explain your answer with
respect to each company's operating leverage.  (5 pts.)

No, they will not continue to have the same net income. The increase in
volume of sales will increase the operating income of Blue Company more than
the net income of Red Company since, looking back at the computations in
Requirement A, Blue company has the higher operating leverage. Moreover,
fixed costs will remain at the same amount, and it is an enough justification on
the greater net income of Blue Company because this company has an increase
in sales but with same amount of deductions as to fixed costs. Blue Company’s
net income is more sensitive to the changes in sales. Another factor that explains
why they will arrive at different income is the variable cost. Red Company has
greater variable costs compare to Blue Company and the increase in volume of
sales will make the variable costs increase as well. That is why Red Company
will get lesser net income than Blue Company.

Computation:
  Blue   Red
Sales (240,000 units) P2,160,000   P2,160,000
Variable costs      960,000     1,440,000
Contribution margin   1,200,000         720,000
Fixed costs      500,000        100,000
Net income P   700,000   P   620,000

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