"Genatron wants to estimate what will happen to its income before interest and taxes if its net sales change from the 2012 level of $1,500,000. Refer to Genatron’s 2012 income statement below, where the income before interest and taxes is $247,000 (EBT of $190,000 plus Interest of $57,000). Assume that the cost of goods sold are variable expenses and that the other operating expenses are fixed.
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Calculate the expected amount of income before interest and taxes for both a 10 percent decrease and a 10 percent increase in net sales for next year.
Percent Change
Current 2012 – 10% 10%
Net sales 1,500,000
Cost of goods sold (variable expenses)
(900,000)
Gross profit
General & administrative (150,000)
Marketing (15,000)
Depreciation (3,000)
Income before interest & taxes 247,000
Determine the percentage change in income before interest and taxes given your calculations in Part a, and determine the degree of operating leverage.
Percent change in operating income
Degree of operating leverage
To calculate the expected amount of income before interest and taxes for a 10 percent decrease and a 10 percent increase in net sales for next year, we need to follow these steps:
1. Calculate the 10 percent decrease and 10 percent increase in net sales:
- For a 10 percent decrease: 1,500,000 * (1 - 0.10) = 1,350,000
- For a 10 percent increase: 1,500,000 * (1 + 0.10) = 1,650,000
2. Calculate the cost of goods sold (variable expenses) based on the net sales figure:
- Cost of goods sold = Net sales * Cost of goods sold as a percentage of net sales (variable expense ratio)
Since the statement does not provide the variable expense ratio, we can assume it to be constant at 60% (900,000/1,500,000).
- For the 10 percent decrease: 1,350,000 * 60% = 810,000
- For the 10 percent increase: 1,650,000 * 60% = 990,000
3. Calculate the gross profit:
- Gross profit = Net sales - Cost of goods sold
- For the 10 percent decrease: 1,350,000 - 810,000 = 540,000
- For the 10 percent increase: 1,650,000 - 990,000 = 660,000
4. Calculate the income before interest and taxes (EBT):
- Income before interest and taxes = Gross profit - Other operating expenses (fixed expenses)
In the given statement, we have general & administrative expenses, marketing expenses, and depreciation as fixed expenses.
- For the 10 percent decrease:
Income before interest and taxes = 540,000 - (150,000 + 15,000 + 3,000) = 372,000
- For the 10 percent increase:
Income before interest and taxes = 660,000 - (150,000 + 15,000 + 3,000) = 492,000
Now, to calculate the percentage change in income before interest and taxes and the degree of operating leverage:
Percentage Change in Income Before Interest and Taxes:
- For the 10 percent decrease: (372,000 - 247,000) / 247,000 * 100 = 50.61%
- For the 10 percent increase: (492,000 - 247,000) / 247,000 * 100 = 99.59%
Degree of Operating Leverage:
- The degree of operating leverage (DOL) can be calculated using the following formula:
DOL = Percentage Change in Income Before Interest and Taxes / Percentage Change in Net Sales
- For the 10 percent decrease: 50.61% / -10% = -5.06
- For the 10 percent increase: 99.59% / 10% = 9.96
Therefore, the expected percentage change in income before interest and taxes is 50.61% for a 10 percent decrease in net sales and 99.59% for a 10 percent increase in net sales. The degree of operating leverage is -5.06 for a 10 percent decrease and 9.96 for a 10 percent increase.