"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, we need to adjust the relevant figures in the income statement.
1. 10% Decrease in Net Sales:
To calculate the new net sales figure, we multiply the current net sales by 0.9 (1 - 10%).
New Net Sales = $1,500,000 * 0.9 = $1,350,000
Using the formula for calculating the income before interest and taxes, which is equal to Gross Profit minus General & Administrative expenses, Marketing expenses, and Depreciation:
Income before interest & taxes = Gross Profit - General & Administrative - Marketing - Depreciation
From the given income statement, the relevant figures are:
Gross Profit = Net Sales - Cost of Goods Sold = $1,500,000 - $900,000 = $600,000
General & Administrative = $150,000
Marketing = $15,000
Depreciation = $3,000
Plugging in these values, we can calculate the expected income before interest and taxes:
Income before interest & taxes = $600,000 - $150,000 - $15,000 - $3,000 = $432,000
2. 10% Increase in Net Sales:
To calculate the new net sales figure, we multiply the current net sales by 1.1 (1 + 10%).
New Net Sales = $1,500,000 * 1.1 = $1,650,000
Using the same formula as above, we can calculate the expected income before interest and taxes:
Income before interest & taxes = $600,000 - $150,000 - $15,000 - $3,000 = $702,000
Next, let's calculate the percentage change in income before interest and taxes for both scenarios.
Percentage Change = (New Value - Old Value) / Old Value * 100
For the 10% decrease:
Percentage Change = ($432,000 - $247,000) / $247,000 * 100 = 75.91%
For the 10% increase:
Percentage Change = ($702,000 - $247,000) / $247,000 * 100 = 183.41%
Finally, to determine the degree of operating leverage, we use the formula:
Degree of Operating Leverage = Percentage Change in Operating Income / Percentage Change in Sales
For this, we need to calculate the percentage change in operating income.
Percentage Change in Operating Income = (Income before interest & taxes - Old EBT) / Old EBT * 100
Old EBT (income before taxes) is given as $247,000.
For the 10% decrease:
Percentage Change in Operating Income = ($432,000 - $247,000) / $247,000 * 100 = 74.79%
For the 10% increase:
Percentage Change in Operating Income = ($702,000 - $247,000) / $247,000 * 100 = 184.62%
Now we can calculate the degree of operating leverage:
Degree of Operating Leverage (Decrease in sales) = 74.79% / 10% = 7.48
Degree of Operating Leverage (Increase in sales) = 184.62% / 10% = 18.46
To summarize:
- For a 10% decrease in net sales, the expected income before interest and taxes is $432,000, with a 75.91% increase in income before interest and taxes and a degree of operating leverage of 7.48.
- For a 10% increase in net sales, the expected income before interest and taxes is $702,000, with a 183.41% increase in income before interest and taxes and a degree of operating leverage of 18.46.