Two firms, A and B, both produce widgets.The price of widgets is $1 each.Firm A has total fixed costs of $500,000 and variable costs of 50' per widget.Firm B has total fixed costs of $240,000 and variable costs of 75' per widget.The corporate tax rate is 40%.If the economy is strong, each firm will sell 1,200,000 widgets.If the economy enters a recession, each firm will sell 1,100,000 widgets. Calculate firm A's degree of operating leverage.

Question

Quizplus · Accepted Answer

The degree of operating leverage is calculated as the percentage change in EBIT divided by the percentage change in sales. In this case, the percentage change in sales is the same for both firms, so we can focus on the percentage change in EBIT.For firm A, the EBIT in the strong economy is $1,200,000 - $500,000 - $500,000 = $200,000. The EBIT in the recession is $1,100,000 - $500,000 - $500,000 = $100,000. The percentage change in EBIT is therefore ($100,000 - $200,000) / $200,000 = -50%.The degree of operating leverage is therefore 50%.

Two Firms, a and B, Both Produce Widgets