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Week 5, LO 8 Demo

# Week 5, LO 8 Demo - affect this change in sales will have...

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Week 5 Week 5 Skill Building Demonstration Problem 8 Compute the degree of operating leverage at a particular level of sales and explain how it can be used to predict changes in net operating income. Learning Objective 8 Degree of Operating leverage = Contribution Margin Net Operating Income Operating Leverage measures the degree to which contribution margin affects net operating income. This helps managers estimate the increase or decrease in operating income when there is a change in the amount of sales. Operating leverage acts as multiplier. A higher degree of operating leverage will cause a large percentage of change in operating income when the percent change in sales is small and sales are near the break- even point. Definitions Conrad Cookware is predicting an increase in sales for the upcoming holiday season. For both factories, there is an expected increase in sales of 20%. The company is looking to see what

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Unformatted text preview: affect this change in sales will have on each factory’s net operating income. Percent Increase in Sales (a) Degree of Operating Leverage (b) Percent Increase in Net Operating Income (a x b) Peoria 20% 2.5 - (\$15,000/\$6,000) 50% Problem Rockford 20% 1.66 -(\$15,000/\$6,000) 33.33% Peoria’s Degree of Operating Leverage = \$15,000 / \$6,000 = 2.5 Rockford’s Degree of Operating Leverage = \$10,000 / \$6,000 = 1.66 Peoria’s Estimated Increase in Operating Income = \$6,000 * 50% = \$3,000 Rockford’s Estimated Increase in Operating Income = \$6,000 * 33.33% = \$2,000 Peoria would have an increase in operating income of \$3,000, while Rockford would only have an increase of \$2,000. The reason for this difference is that Peoria’s operating income is more sensitive to a change in sales because it has a higher contribution margin. Solution...
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