The Solemn Company has an operating leverage of 2. Sales for 2016 are $100,000 with a contribution margin of $50,000. Sales are expected to be $150,000 in 2017. Operating income for 2017 can be expected to increase by what amount over 2016?

Question

Quizplus · Accepted Answer

Operating leverage = Contribution margin/Operating income
2 = $50,000/X
X = $25,000 (operating income in 2016)
Using the same operating leverage, operating income in 2017 can be calculated as:
2 = $75,000/Y
Y = $37,500
Therefore, expected operating income in 2017 is $37,500. The increase in operating income from 2016 to 2017 is:
$37,500 - $25,000 = $12,500
However, since sales are expected to increase by 50%, contribution margin will also increase by 50% (i.e. $50,000 x 1.5 = $75,000). Using the same operating leverage, operating income in 2017 can also be calculated as:
2 = $75,000/Z
Z = $37,500 (same as before)
Therefore, expected operating income in 2017, taking into account the increase in sales, is:
$37,500 + ($12,500 x 1.5) = $56,250
The increase in operating income from 2016 to 2017, taking into account the increase in sales, is:
$56,250 - $25,000 = $31,250
However, the question asks for the increase in operating income over 2016 without taking into account the increase in sales. Therefore, the answer is $50,000 (the contribution margin for 2016, which is expected to remain constant, and is therefore the only factor influencing the increase in operating income).

The Solemn Company Has an Operating Leverage of 2