If a company has fixed costs and is operating above the breakeven point, when sales increase by 15%, profits will:
a. increase by less than 15%
b. increase by 15%
c. increase by more than 15%
d. decrease by less than 15%
I am thinking that the answer is c because if the company is operating above its breakeven point and the fixed costs are constant then the profits should increase by more than 15% since they aren't receiving any additional costs.
To calculate the effect of a 15% increase in sales on profits when a company has fixed costs and is operating above the breakeven point, we need to understand the concept of operating leverage.
Operating leverage refers to the extent to which fixed costs are being used in a company's operations. When a company has high fixed costs, it means that a significant portion of its costs do not change with changes in sales volume.
To calculate the effect of a 15% increase in sales on profits, we need to consider the contribution margin ratio (CMR) and the degree of operating leverage (DOL).
The contribution margin ratio is calculated by subtracting variable costs from sales and dividing the result by sales. It represents the amount of each sales dollar that will contribute towards covering fixed costs and generating profit.
The degree of operating leverage is calculated by dividing contribution margin by net operating income (profit). It measures how much a change in sales will affect profit.
Using these calculations, we can determine the effect of a 15% increase in sales on profits:
1. Calculate the contribution margin:
CMR = (Sales - Variable Costs) / Sales
2. Calculate the degree of operating leverage:
DOL = Contribution Margin / Net Operating Income
3. Calculate the percentage change in profit using the DOL:
% Change in Profit = DOL × % Change in Sales
Now, let's examine the answer choices:
a. Increase by less than 15%: If the DOL is less than 1, then the % Change in Profit will be less than the % Change in Sales. So, this answer is possible if the company has low operating leverage.
b. Increase by 15%: This answer assumes that the DOL is equal to 1. In this case, the % Change in Profit would be equal to the % Change in Sales.
c. Increase by more than 15%: If the DOL is greater than 1, then the % Change in Profit will be greater than the % Change in Sales. This answer is possible if the company has high operating leverage.
d. Decrease by less than 15%: This answer is unlikely because the company is operating above the breakeven point, meaning it is making a profit. A 15% increase in sales should generally lead to an increase in profits or at least maintain them, depending on the DOL.
In conclusion, the correct answer is either b. Increase by 15% or c. Increase by more than 15%. The specific answer depends on the company's degree of operating leverage (DOL).