If a company has a degree of operating leverage of 2.0 and sales increase by 25%,then:

Question

Quizplus · Accepted Answer

The degree of operating leverage (DOL) is the ratio of contribution margin to net operating income. DOL measures a company's operating leverage, which is the extent to which fixed costs are used in the production process. A higher DOL indicates that a company has higher fixed costs relative to variable costs.

DOL = contribution margin / net operating income

If sales increase by 25%, then contribution margin will also increase by 25%. Therefore, we can calculate the new net operating income as follows:

New net operating income = old net operating income + (DOL x (new contribution margin - old contribution margin))

New net operating income = old net operating income + (2.0 x 0.25 x old contribution margin)

New net operating income = old net operating income + 0.5 x old contribution margin

Thus, profit will increase by 50%, making answer C the correct choice. Total variable costs may or may not change, so answer D is incorrect. Answer A is incorrect because profit would increase by 50%, not 20%.

If a Company Has a Degree of Operating Leverage of 2.0