CHAPTER 15

Analysis and Impact

of Leverage
CHAPTER ORIENTATION
This chapter focuses on useful aids for the financial manager in determining the firm's
proper financial structure. It includes the definitions of the different kinds of risk, a review
of breakeven analysis, the concepts of operating leverage, financial leverage, the
combination of both leverages, and their effect on EPS (earnings per share).

CHAPTER OUTLINE

I. Business risk and financial risk

A. Risk is defined as the likely variability associated with expected revenue
streams.
1. The variations in the income stream can be attributed to
a. The firm's exposure to business risk
b. The firm's decision to incur financial risk
B. Business risk is defined as the variability of the firm's expected earnings
before interest and taxes.
1. Business risk is measured by the firm's corresponding expected
coefficient of variation.
2. Dispersion in operating income does not cause business risk. It is the
result of several influences, such as the company’s cost structure,
product demand characteristics, and intra-industry competition.
C. Financial risk is a direct result of the firm's financing decision. It refers to the
additional variability in earnings available to the firm’s common
stockholders and the additional chance of insolvency borne by the common
shareholder when financial leverage is used.
1. Financial leverage is the financing of a portion of the firm's assets
with securities bearing a fixed rate of return in hopes of increasing the
return to the common shareholders.

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 2. Financial risk is passed on to the common shareholders who must
bear most of the inconsistencies of returns to the firm after the
deduction of fixed payments.
II. Break-even Analysis
A. The objective of break-even analysis is to determine the break-even quantity
by studying the relationships among the firm’s cost structure, volume of
output, and operating profit.
1. The break-even quantity of output results in an EBIT level equal to
zero.
B. Use of the model enables the financial officer to
1. Determine the quantity of output that must be sold to cover all
operating costs.
2. Calculate the EBIT achieved at various output levels.
C. Some potential applications include
1. Capital expenditure analysis as a complementary technique to
discounted cash flow evaluation models
2. Pricing policy
3. Labor contract negotiations
4. Evaluation of cost structure
5. Financial decisions making
D. Essential elements of the break-even model
1. Production costs must be separated into fixed costs and variable costs.
Fixed costs do not vary as the sales volume or the quantity of output
changes. Examples include
a. Administrative salaries
b. Depreciation
c. Insurance premiums
d Property taxes
e. Rent
2. Variable costs vary in total as output changes. Variable costs are fixed
per unit of output. Examples include
a. Direct materials
b. Direct labor
c. Energy cost associated with production
d. Packaging
e. Freight-out
f. Sales commissions

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 3. In order to implement the break-even model, it is necessary for the
financial manager to
a. Identify the most relevant output range for planning purposes.
b. Approximate all costs in the semifixed and semivariable range
and allocate them to the fixed and variable cost categories.
4. Total revenue and volume of output
a. Total revenue (sales dollars) is equal to the selling price per
unit multiplied by the quantity sold.
b. Volume of output refers to the firm’s level of operations and
is expressed as a unit quantity or sales dollars.
E. Finding the break-even point
1. The break-even model is just an adaptation of the firm's income
statement expressed as
sales - (total variable costs + total fixed costs) = profit
2. Three ways to find the break-even point are explained.
a. Trial and error
(1) Select an arbitrary output level.
(2) Calculate the corresponding EBIT amount.
(3) When EBIT equals zero, the break-even point has been
found.
b. Contribution margin analysis
(1) Unit selling price—unit variable cost = contribution
margin
(2) Fixed cost divided by the contribution margin equals
the break-even quantity in units.
c. Algebraic analysis
(l) QB = the break-even level of units sold,
P = the unit sales price,
F = the total fixed cost for the period,
V = unit variable cost.
(2) Then,
F
QB =
PV

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 F. The break-even point in sales dollars
1. It is convenient to calculate the break-even point in terms of sales
dollars if the firm deals with more than one product. It can be
computed by using data from the firm's annual report.
2. Since variable cost and selling price per unit are assumed constant,
the ratio of total sales to total variable costs is a constant for any level
of sales.
G. Limitations of break-even analysis
1. Assumes linear cost-volume-profit relationship.
2. The total revenue curve is presumed to increase linearly with the
volume of output.
3. Assumes constant production and sales mix.
4. This is a static form of analysis.
III. Operating Leverage
A. Operating leverage is the responsiveness of a firm's EBIT to fluctuations in
sales. Operating leverage results when fixed operating costs are present in
the firm's cost structure.
B. This responsiveness can be measured as follows:
degree of operating % change in EBIT
leverage from the = DOLs =
% change in sales
base sales level
C. If unit costs are available, the DOL can be measured by
Q(P  V)
DOLs =
Q(P  V)  F

D. If an analytical income statement is the only information available, the

following formula is used:
revenue before fixed costs S  VC
DOLs = =
EBIT S  VC  F
Note: All three formulas provide the same results.
E. Implications of operating leverage
1. At each point above the break-even level, the degree of operating
leverage decreases.
2. At the break-even level of sales, the degree of operating leverage is
undefined.
3. Operating leverage is present when the percentage change in EBIT
divided by the percentage change in sales is greater than one.
4. The degree of operating leverage is attributed to the business risk that
a firm faces.

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IV. Financial Leverage
A. To see if financial leverage has been used to benefit the common
shareholder, focus will be on the responsiveness of the company's earning per
share (EPS) to changes in its EBIT.
B. The firm is using financial leverage and is exposing its owners to financial
risk when
% change in EPS
% change in EBIT
is greater than 1.00

C. A measure of the firm's use of financial leverage is as follows:

degree of financial % change in EPS
leverage from the = DFLEBIT =
% change in EBIT
base EBIT level
1. The degree of financial leverage concept can be either in the positive
or negative direction.
2. The greater the degree of financial leverage, the greater the
fluctuations in EPS.
D. An easier way to measure financial leverage is
EBIT
DFLEBIT =
EBIT  I
where I is the sum of all fixed financing costs
V. Combining operating and financial leverage
A. Changes in sales revenues cause greater changes in EBIT. If the firm
chooses to use financial leverage, changes in EBIT turn into larger variations
in both EPS and EAC. Combining operating and financial leverage causes
rather large variations in EPS.
B. One way to measure the combined leverage can be expressed as
degree of combined % change in EPS
leverage from the = DCLs =
% change in sales
base sales level
If the DCL is equal to 5.0 times, then a 1% change in sales will result in a
5% change in EPS.
C. The degree of combined leverage is the product of the two independent
leverage measures. Thus:
DCLS = (DOLS ) x (DFLEBIT)

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 D. Another way to compute DCLs is with the following equation:
Q(P  V)
DCLs =
Q(P  V)  F  I

E. Implications of combining operating and financial leverage

1. Total risk can be managed by combining operating and financial
leverage in different degrees.
2. Knowledge of the various leverage measures helps to determine the
proper level of overall risk that should be accepted.

ANSWERS TO
END-OF-CHAPTER QUESTIONS

15-1. Business risk is the uncertainty that envelops the firm's stream of earnings before
interest and taxes (EBIT). One possible measure of business risk is the coefficient of
variation in the firm's expected level of EBIT. Business risk is the residual effect of
the: (1) company's cost structure, (2) product demand characteristics, (3) intra-
industry competitive position. The firm's asset structure is the primary determinant
of its business risk. Financial risk can be identified by its two key attributes: (1) the
added risk of insolvency assumed by the common stockholder when the firm
chooses to use financial leverage; (2) the increased variability in the stream of
earnings available to the firm's common stockholders.
15-2. Financial leverage is financing a portion of the firm's assets with securities bearing a
fixed (limited) rate of return. Anytime the firm uses preferred stock to finance
assets, financial leverage is employed.
15-3. Operating leverage is the use of operating fixed costs in the firm's cost structure.
When operating leverage is present, any percentage fluctuation in sales will result in
a greater percentage fluctuation in EBIT.
15-4. Break-even analysis, as it is typically presented, categorizes all operating costs as
being either fixed or variable. Based upon this division of costs, the break-even
point is computed. The computation procedure for the cash break-even point omits
any noncash expenses that the firm might incur. Typical examples of noncash
expenses include depreciation and prepaid expenses. The ordinary break-even point
will always exceed the cash break-even point, provided some noncash charges are
present.
15-5. The most important shortcomings of break-even analysis are:
(1) The cost-volume-profit relationship is assumed to be linear over the entire
range of output.
(2) All of the firm's production is assumed to be saleable at the fixed selling
price.
(3) The sales mix and production mix is assumed constant.

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 (4) The level of total fixed costs and the variable cost to sales ratio is held
constant over all output and sales ranges.
15-6. Total risk exposure is the result of the firm's use of both operating leverage and
financial leverage. Business risk and financial risk produce this total risk. A
company that is normally exposed to a high degree of business risk may manage its
financial structure in such a way as to minimize financial risk. A firm that enjoys a
stable pattern in its earnings before interest and taxes might reasonably elect to use a
high degree of financial leverage. This would increase both its earnings per share
and its rate of return on the common equity investment.
15-7. By taking the degree of combined leverage times the sales change of a negative 15
percent, the earnings available to the firm's common shareholders will decline by 45
percent.
15-8. As the sales of a firm increase, two things occur that bias the cost and revenue
functions toward a curvilinear shape. First, sales will increase at a decreasing rate.
As the market approaches saturation, the firm must cut its price to generate sales
revenue. Second, as production approaches capacity, inefficiencies occur that result
in higher labor and material costs. Furthermore, the firm's operating system may
have to bear higher administrative and fixed costs. The result is higher per unit costs
as production output increases.

SOLUTIONS TO
END-OF-CHAPTER PROBLEMS

SOLUTIONS TO PROBLEM SET A

15-1A.

Product Line Sales V.C. C.M. C.M. Ratio

Piano 61,250 41,650 19,600 32%
Violin 37,500 22,500 15,000 40%
Cello 98,750 61,225 37,525 38%
Flute 52,500 25,725 26,775 51%
Total 250,000 151,100 98,900 40%

Break-even Point
S = F/(1-VC/S) = 50,000/(1-VC/S) = 50,000/.4 = 125,000

F 50,000
50,000
S = 1  VC  =  $151,100  = = 125,000
  1   .4
 S   $250,000 

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15-2A. Break-even Quantity = QB

F
QB = (P  V)

$360,000
QB = $30 - (.70)($30)

QB = 40,000 bottles

15-3A. Degree of Operating Leverage = DOLS

Q(P  V)
DOLS =
[Q(P  V)  F]

V = 70% x $30 =$21

50,000($30  $21)
DOLS =
[50,000($30  $21)  $360,000]

DOLS = 5 times
15-4A.
(a)
Jake's Sarasota Jefferson
Lawn Chairs Sky Lights Wholesale
Sales $600,640.00 $2,450,000 $1,075,470
Variable Costs $326,222.60 $1,120,000 $957,000
Revenue before
fixed costs $274,417.40 $1,330,000 $118,470
Fixed costs $120,350.00 $850,000 $89,500
EBIT $ 154,067.40 $ 480,000 $ 28,970

(b)
F $120,350
Jake's Lawn Chairs: QB = =
PV $32  $17.38

$120,350
= = 8,232
$14.62

$850,000
Sarasota Skylights: QB = = $850,000 = 1,789
$875  $400 $475

$89,500
Jefferson Wholesale: QB = = $89,500 = 8,310
$97.77  $87 $10.77
(c)
Jake's Sarasota Jefferson
Lawn Chairs Skylights Wholesale

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 RevenueBefore $274,417.40 $1,330,000 $118,470
FixedCosts =
$154,067.40 $480,000 $28,970
EBIT
= 1.78 times 2.77 times 4.09 times
(d) Jefferson Wholesale, since its degree of operating leverage exceeds that of
the other two companies.

15-5A.
Rev Before Fixed Costs $22,950,000
(a) = = 1.67 times
EBIT $13,750,000

EBIT $13,750,000
(b) = =
EBIT  I $13,750,000  $1,350,000
$13,750,000
= 1.11 times
$12,400,000

(c) DCL45,750,000 = (1.67) (1.11) = 1.85 times

F $9,200,000
$9,200,000
(d) S* = VC = $22,800,000 =
1 1 1  .498
S $45,750,000
$9,200,000
= = $18,326,693.23
.502

(e) (25%) × (1.85) = 46.25%

15-6A.
F $170,000 $170,000
(a) QB = = = = 6,296 pairs of shoes
PV $85  $58 $27

F $170,000
$170,000 $170,000
(b) S* = 1  VC = 1  $58 = = = $534,591.20
1  .682 .318
S $85
(c)
7,000 9,000 15,000
Pairs of Shoes Pairs of Shoes Pairs of Shoes
Sales $595,000 $765,000 $1,275,000
Variable Costs 406,000 522,000 870,000
Revenue before
fixed costs $189,000 $243,000 $405,000
Fixed costs 170,000 170,000 170,000
EBIT $ 19,000 $ 73,000 $ 235,000
(d)
7,000 9,000 15,000
Pairs of Shoes Pairs of Shoes Pairs of Shoes

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 $189,000 $243,000 $405,000
$19,000 $73,000 $235,000

= 9.95 times 3.33 times 1.72 times

Notice that the degree of operating leverage decreases as the firm's sales level
rises above the break-even point.

15-7A.
F $630,000 $630,000
(a) QB = = = = 9000 Units
PV $180  $110 $70

(b) S* = 9000 units × $180 = $1,620,000

Alternatively,
F $630,000
S* = VC = $110
1 1
S $180

$630,000 $630,000
= = = $1,619,954
1  0.6111 .3889

Note: $1,619,954 differs from $1,620,000 due to rounding.

(c) 12,000 15,000 20,000

units units units
Sales $2,160,000 $2,700,000 $3,600,000
Variable Costs 1,320,000 1,650,000 2,200,000
Revenue before
fixed costs 840,000 1,050,000 1,400,000
Fixed costs 630,000 630,000 630,000
EBIT $ 210,000 $ 420,000 $ 770,000

(d) 12,000 units 15,000 units 20,000 units

$840,000 $1,050,000 $1, 400,000

$210,000 $420,000 $770,000

= 4 times = 2.5 times = 1.82 times

Notice that the degree of operating leverage decreases as the firm's sales level
rises above the break-even point.

15-8A. (a)
Blacksburg Lexington Williamsburg
Furniture Cabinets Colonials
Sales $1,125,000 $1,600,000 $520,000
Variable costs 926,250 880,000 188,500

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 Revenue before
fixed costs $198,750 $720,000 $331,500
Fixed costs 35,000 100,000 70,000
EBIT $163,750 $620,000 $261,500

(b)
Blacksburg F $35,000 $35,000
Furniture : QB = = = = 13,208
PV $15.00  $12.35 $2.65
units

Lexington $100,000 $100,000

Cabinets : QB = $400  $220 = = 556 units
$180

Williamsburg $70,000 $70,000

Colonials :
QB = = = 2745 units
$40.00  $14.50 $25.50

(c)
Blacksburg Lexington Williamsburg
Furniture Cabinets Colonials
Revenue Before $198,750 $720,000 $331,500
Fixed Costs
$163,750 $620,000 $261,500
EBIT
= 1.21 times 1.16 times 1.27 times

(d) Williamsburg Colonials, since its degree of operating leverage

exceeds that of the other two companies.

15-9A.
(a)
{S- (V + F)} (1-T) = $50,000

 VC 
{S – [S   + F]} (1-T) = $50,000
 P 

{$375,000 - $206,250 – F} (0.6) = $50,000

($168,750 - F) (0.6) = $50,000

F = $85,416.67

(b) QB = F = $85,416.67 = $85,416.67 = 7,030 units

PV $27.00  $14.85 $12.15

F
$85,416.67
S* = 1  VC = = $189,815
1  .55
S

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15-10A.(a) Find the EBIT level at the forecast sales volume:
EBIT
= .26
S
Therefore, EBIT = (0.26) ($3,250,000) = $845,000

Next, find total variable costs:

VC
= 0.5,
S
so, VC = (0.5) $3,250,000 = $1,625,000

Now, solve for total fixed costs:

S - (VC + F) = $845,000

$3,250,000 - ($1,625,000 + F) = $845,000

F = $780,000

$780,000
(b) S* = = $1,560,000
1  0. 5

15-11A.
Revenue before Fixed costs $16,500,000
(a) = = 1.94 times
EBIT $8,500,000

EBIT $8,500,000
(b) = = 1.13 times
EBIT  I $7,500,000

(c) DCL$30,000,000= (1.94) × (1.13) = 2.19 times

F $8,000,000
$8,000,000 $8,000,000
(d) S* = 1  VC = 1  $13.5m = = =
1  0.45 0.55
S $30.0m
$14,545,455

(e) (25%) × (2.19) = 54.75%

15-12A.Given the data for this problem, several approaches are possible for finding the
break-even point in units. The approach below seems to work well with students.

Step (1) Compute the operating profit margin:

Operating Profit Margin x Operating Asset Turnover = Return
on operating assets
(M) x (5) = 0.25
M = .05

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Step (2) Compute the sales level associated with the given output level:
Sales
= 5
$20,000,000

Sales = $100,000,000

Step (3) Compute EBIT:

(.05) ($100,000,000) = $5,000,000

Step (4) Compute revenue before fixed costs. Since the degree of
operating leverage is 4 times, revenue before fixed costs
(RBF) is 4 times EBIT as follows:
RBF = (4) ($5,000,000) = $20,000,000

Step (5) Compute total variable costs:

(Sales) - (Total variable costs) = $20,000,000
$100,000,000 - (Total variable costs) = $20,000,000
Total variable costs = $80,000,000

Step (6) Compute total fixed costs:

RBF - Fixed costs = $5,000,000
$20,000,000 - fixed costs = $5,000,000
Fixed costs = $15,000,000

Step (7) Find the selling price per unit, and the variable cost per unit:
$100,000,000
P = = $10.00
10,000,000
$80,000,000
V = = $8.00
10,000,000

Step (8) Compute the break-even point:

QB = F = $15,000,000 = $15,000,000 = 7,500,000
PV ($10)  ($8) $2
units

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15-13A.
(a) QB = F = $540,000 = $540,000 = 10,000 units
PV $180  $126 $54
F $540,000
$540,000 $540,000
(b) S* = VC = $126 = =
1 1 1  0.7 .3
S $180
= $1,800,000

(c) 12,000 15,000 20,000

Units Units Units
Sales $2,160,000 $2,700,000 $3,600,000
Variable costs 1,512,000 1,890,000 2,520,000
Revenue before fixed costs $ 648,000 $ 810,000 $1,080,000
Fixed costs 540,000 540,000 540,000
EBIT $ 108,000 $ 270,000 $ 540,000

(d) 12,000 units 15,000 units 20,000 units

$648,000 $810,000 $1,080,000

= 6 times = 3 times = 2 times
$108,000 $270,000 $540,000

Notice that the degree of operating leverage decreases as the firm's sales level
rises above the break-even point.

15-14A.
(a) Oviedo Gainesville Athens
Seeds Sod Peaches
Sales $1,400,000 $2,000,000 $1,200,000
Variable costs 1,120,000 1,300,000 840,000
Revenue before fixed costs $280,000 $ 700,000 $ 360,000
Fixed costs 25,000 100,000 35,000
EBIT $ 255,000 $ 600,000 $ 325,000

(b) Oviedo Seeds: QB = F = $25,000 = $25,000

PV $14 .00  $11 . 20 $2.80
= 8,929 units
$100,000 $100,000
Gainesville Sod: QB = =
$200  $130 $70
= 1,429 units

Athens Peaches: QB = $35,000 = $35,000

$25.00  $17.50 $7.50

= 4,667 units

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 (c)
Oviedo Gainesville
Seeds Sod
$280,000 $700,000
= 1.098 times = 1.167 times
$255,000 $600,000

Athens
Peaches
$360,000
= 1.108 times
$325,000

(d) Gainesville Sod, since its degree of operating leverage exceeds that of the
other two companies.

15-15A.
(a) {S - [V + F]} (1 - T) = $40,000
V
{S – [S   + F]} (1-T) = $40,000
P
{($400,000) - ($160,000) - F} (0.6) = $40,000
($240,000 - F) (0.6) = $40,000
F = $173,333.33

(b) Q = F = $173,333.33 = 14,444 units

B PV $12

F
$173,333.33
S* = VC = = $288,888.88
1 1  0.40
S

15-16A.
(a) {S - [V + F] } (1-T) = $80,000
V
{S – [S   + F]} (1-T) = $80,000
P
{($2,000,000) - (1,400,000) - F} (.6) = $80,000
($600,000 - F) (.6) = $80,000
$360,000 - .6F = $80,000
F = $466,666.67

(b) QB = F = $466,666.67 = 19,444 units

PV $24

360
 F
$466,666.67 $466,666.67
S* = VC = =
1 1  .7 .3
S

= $1,555,555.57

15-17A.
(a) S (1 - 0.75) - $300,000 = $240,000
0.25S = $540,000
S = $2,160,000 = (P × Q)

Now, solve the above relationship for P:

200,000 (P) = $2,160,000
P = $10.80

(b) Sales $2,160,000

Less: Total variable costs 1,620,000
Revenue before fixed costs $540,000
Less: Total fixed costs 300,000
EBIT $ 240,000

15-18A.
(a) S (1 - .6) - $300,000 = $250,000
.4S = $550,000
S = $1,375,000 = (P × Q)

Solve the above relationship for P.

200,000 (P) = $1,375,000
P = $6.875

(b) Sales $1,375,000

Less: Total variable costs 825,000
Revenue before fixed costs $550,000
Less: Total fixed costs 300,000
EBIT $ 250,000

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15-19A.
(a) First, find the EBIT level at the forecast sales volume:
= 0.28
So: EBIT = (0.28) $3,750,000 = $1,050,000
Next, find total variable costs:
= 0.5

So: VC = (0.50) $3,750,000 = $1,875,000

Then, solve for total fixed costs:

S - (VC + F) = $1,050,000

$3,750,000 - ($1,875,000 + F) = $1,050,000

F = $825,000

(b) S* = $825,000 = $1,650,000

1  0.5

15-20A.
F $180,000
(a) QB = = = 1,200 units
PV $150

F
$180,000
(b) S* = VC = = $600,000
1 1  0.70
S

5,000($500  $350)
(c) DOL$2,500,000 =
5,000($500  $350)  $180,000

$750,000
= 1.316 times
$570,000

(d) (20%) x (1.316) = 26.32%

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15-21A.
(a) QB = F = $50,000 = $50,000 = 5,000 units
PV $25  $15 $10

F $50,000
$50,000 $50,000
(b) S* = 1  VC = 1  $15 = = = $125,000
1  0.6 .4
S $25

(c) 4000 units 6000 units 8000 units

Sales $100,000 $150,000 $200,000
Variable costs 60,000 90,000 120,000
Revenue before fixed costs $ 40,000 $ 60,000 $ 80,000
Fixed costs 50,000 50,000 50,000
EBIT $-10,000 $ 10,000 $ 30,000

(d) 4000 units 6000 units 8000 units

$40,000 $60,000 $80,000

= -4X = 6X = 2.67X
 $10,000 $10,000 $30,000

(e) The degree of operating leverage decreases as the firm's sales level rises
above the break-even point.

15-22A. Compute the present level of break-even output:

Q = F = $120,000 = 24,000 units

B PV $12  $7

Compute the new level of fixed costs at the break-even output:

S–V–F=0
($12) (24,000) - ($5) (24,000) - F = 0
$288,000 - $120,000 - F = 0
$168,000 = F

Compute the addition to fixed costs:

$168,000 - $120,000 = $48,000 addition

363
 30,000($12  $7)
15-23A. DOL$360,000 =
30,000($12  $7)  $120,000

$150,000
= = 5 times
$30,000

Any percentage change in sales will magnify EBIT by a factor of 5.

15-24A.
40,000($12  $7)
(a) DOL$480,000 =
40,000($12  $7)  120,000

$200,000
= = 2.5 times
$80,000

(b) DFL$80,000 = $80,000 = 1.6 times

$80,000  $30,000

40,000($12  $7)
(c) DCL$480,000 =
40,000($12  $7)  $120,000  $30,000
$200,000
= = 4 times
$50,000
Alternatively:
(DOLS) x (DFLEBIT) = DCLS
(2.5) x (1.6) = 4 times

15-25A. The task is to find the break-even point in units for the firm. Several
approaches are possible, but the one presented below makes intuitive sense to
students.

Step (1) Compute the operating profit margin:

(Operating Profit Margin) x (Operating Asset Turnover) =
Return on Operating Assets
(M) x (5) = 0.15
M = 0.03

Step (2) Compute the sales level associated with the given output level:
Sales
= 5
$3,000,000
Sales = $15,000,000

Step (3) Compute EBIT:

(0.03) ($15,000,000) = EBIT = $450,000

364
 Step (4) Compute revenue before fixed costs. Since the degree of
operating leverage is 8 times, revenue before fixed costs
(RBF) is 8 times EBIT as follows:

RBF = (8) ($450,000) = $3,600,000

Step (5) Compute total variable costs:

Sales - Total variable costs = $3,600,000
$15,000,000 - Total variable costs = $3,600,000
Total variable costs = $11,400,000

Step (6) Compute total fixed costs:

RBF - Fixed costs = $450,000
$3,600,000 - Fixed costs = $450,000
Fixed costs = $3,150,000

Step (7) Find the selling price per unit, and the variable cost per unit:
$15,000,000
P = = $9.375
1,600,000
$11,400,000
V = = $7.125
1,600,000

Step (8) Compute the break-even point:

F $3,150,000
QB = = ($9.375)  ($7.125) =
PV
$3,150,000
= 1,400,000 units
$2.25

15-26A. Compute the present level of break-even output:

QB = F = $300,000 = 50,000 units
PV $20  $14
Compute the new level of fixed costs at the break-even output.
S–V–F=0
($20) (50,000) - ($12) (50,000) – F = 0
$400,000 = F

Compute the addition to fixed costs:

$400,000 - $300,000 = $100,000 addition

15-27A.
Revenue before fixed costs $3,000,000
(a) = = 3 times
EBIT $1,000,000

365
 EBIT $1,000,000
(b) = = 1.25 times
EBIT  I $800,000

(c) DCL$12,000,000 = (3) × (1.25) = 3.75 times

F 2,000,000
(d) S* = 1  VC = 1  $9m =
S $12m

$2,000,000 $2,000,000
= = $8,000,000
1  0.75 0.25

15-28A.
Revenue before fixed costs $8,000,000
(a) = = 2 times
EBIT $ 4,000,000

EBIT $4,000,000
(b) = = 1.6 times
EBIT  I $2,500,000

(c) DCL$16,000,000 = (2) (1.6) = 3.2 times

(d) (20%) (3.2) = 64%

F $4,000,000
(e) S* = 1  VC = 1  $8m =
S $16m
$4,000,000
= $8,000,000
1  0.5

366
15-29A. A B C D Total
Sales $40,000 $50,000 $20,000 $10,000 $120,000
Variable costs* 24,000 34,000 16,000 4,000 78,000
Contribution margin $16,000 $16,000 $ 4,000 $ 6,000 $ 42,000
Contribution margin ratio 40% 32% 20% 60% 35%
*Variable costs = (Sales) (1 - contribution margin ratio)
Break-even point in sales dollars:
F
$29,400 $29,400
S* = 1  VC = = = $84,000
1  0.65 0.35
S
15-30A. A B C D Total
Sales $30,000 $44,000 $40,000 $6,000 $120,000
Variable costs* 18,000 29,920 32,000 2,400 82,320
Contribution margin $12,000 $14,080 $ 8,000 $ 3,600 $ 37,680
Contribution margin ratio 40% 32% 20% 60% 31.4%
*Variable costs = (sales) (1- contribution margin ratio).
Break-even point in sales dollars:
F
$29,400
S* = 1  VC = = $93,631
0.314
S

Toledo's management would prefer the sales mix identified in problem 15-29A.
That sales mix provides a higher EBIT ($12,600 vs. $8,280) and a lower break-even
point ($84,000 vs. $93,631).

SOLUTION TO INTEGRATIVE PROBLEM:

In solving for the break-even point in units, the following step-by-step approach seems to be
the most logical to students and the easiest for them to understand.

COMPUTE BREAK-EVEN POINT:

STEP 1: Compute the operating profit margin:

Operating Profit Margin [M] x Operating Asset Turnover = Return on
operating assets
M x 7 = 35%
M = 5%

367
STEP 2: Compute the sales level associated with the given output level:
Operating Assets x Operating Asset Turnover = Sales
$2,000,000 x 7 = Sales
Sales = $14,000,000

STEP 3: Compute EBIT:

Sales [STEP 2] x Operating Profit Margin [STEP 1] = EBIT
$14,000,000 x 5% = EBIT
EBIT = $700,000

STEP 4: Compute revenue before fixed costs:

EBIT [STEP 3] x Degree of Operating Leverage = Revenue before Fixed
Costs
$700,000 x 5 = Revenue before Fixed Costs
Revenue before Fixed Costs = $3,500,000

STEP 5: Compute total variable costs:

Sales [STEP 2] - Revenue before Fixed Costs [STEP 4] = Total Variable
Costs
$14,000,000 - $3,500,000 = Total Variable Costs
Total Variable Costs = $10,500,000

STEP 6: Compute total fixed costs:

Revenue before Fixed Costs [STEP 4] - EBIT [STEP 3] = Fixed Costs
$3,500,000 - $700,000 = Fixed Costs
Fixed Costs = $2,800,000

STEP 7: Find selling price per unit (P) and variable cost per unit (V):
P = Sales [STEP 2] / Output in Units
P = $14,000,000 / 50,000 units
P = $280.00
V = Total Variable Costs [STEP 5] / Output in Units
V = $10,500,000 / 50,000 units
V = $210.00

368
STEP 8: Compute break-even point (in units):
QB = F [STEP 6] / (P - V) [STEP 7]
QB = $2,800,000 / ($280.00 - $210.00)
QB = 40,000 units

After determining the break-even point using the approach described above, the students
have the information necessary to prepare an analytical income statement as follows:

Sales [STEP 2] $14,000,000

Variable Costs [STEP 5] 10,500,000
Revenue before Fixed Costs $3,500,000
Fixed Costs [STEP 6] 2,800,000
EBIT $700,000
Interest Expense 400,000
Earnings Before Taxes $300,000
Taxes (35%) 105,000
Net Income $195,000
Thereafter, the students have the data they need to answer questions (a) - (e) as follows:

(a) Degree of financial leverage:

DFLEBIT = EBIT / (EBIT - Interest)
DFLEBIT = $700,000 / ($700,000 - $400,000)
DFLEBIT = 2.33

(b) Degree of Combined Leverage:

DCLS = DOLS x DFLEBIT
DCLS = 5 x 2.33
DCLS = 11.65

(c) Break-even point in sales dollars:

F
S* =
1 V
S
$2,800,000
S* =
1 - $10,500,000
$14,000,000
S* = $11,200,000

(d) “If sales increase 30%, by what percent would EBT increase?”
% increase in EBT = % increase in Sales x DCLS
% increase in EBT = 30% x 11.65
% increase in EBT = 350%

369
 (e) Analytical Income Statement to verify effect of 30% increase in sales:

Sales] $18,200,000
Variable Costs 13,650,000
Revenue Before Fixed Costs $4,550,000
Fixed Costs [STEP 6] 2,800,000
EBIT $1,750,000
Interest Expense 400,000
Earnings Before Taxes $1,350,000
Taxes (35%) 472,500
Net Income $877,500

It may be useful to develop the following “proof” to assist in explaining the inter-
relationships of the various values:
% change in EBT = (EBTafter - EBTbefore) / EBTbefore
% change in EBT = ($1,350,000 - $300,000) / $300,000
% change in EBT = 350%
which agrees with the following:
% change in EBT = % change in Sales x DCLS
% change in EBT = 30% x 11.65
% change in EBT = 350%

SOLUTIONS TO PROBLEM SET B

15-1B. Break-even Quantity = QB

F
QB = (P  V)
$20,000,000
P = = $.50 per unit
40,000,000 units
$16,000,000
V = = $.40 per unit
40,000,000 units
thus,
$2,400,000
QB = ($0.50  $0.40)

QB = 24,000,000 units

370
15-2B. Degree of Combined Leverage = DCLS
Degree of Operating Leverage = DOLS
Degree of Financial Leverage = DFLEBIT

Q(P  V)
DOLS =
[Q(P  V)  F]
$20,000,000
P = = $.50 per unit
40,000,000 units
$16,000,000
V = = $.40 per unit
40,000,000 units

thus,
40,000,000 ($0.50  $0.40)
DOLS =
 40,000,000 ($0.50  $0.40)  $2,400,000
DOLS = 2.50 times
EBIT
DFLEBIT = (EBIT  1)
$1,600,000
DFLEBIT = ($1,600,000  $800,000)

DFLEBIT = 2.00 times

and
Q(P  V)
DCLS =
[Q(P  V)  F  I]

40,000,000 ($0.50  $0.40)

DCLS =
 40,000,000 ($0.50  $0.40)  $2,400,000  $800,000
$4,000,000
DCLS =
$800,000
DCLS = 5.00 times

15-3B.
F $650,000 $650,000
(a) QB = = = = 10,833 Units
PV $ 175  $115 $60

371
 (b) S* = (10,833 units) × ($175) = $1,895,775
Alternatively,
F $650,000
S* = VC = 1  $115
1
S $175
$650,000 $650,000
= = = $1,895,833
1  0.6571 .3429
Note: $1,895,833 differs from $1,895,775 due to rounding.

(c) 10,000 16,000 20,000

units units units
Sales $1,750,000 $2,800,000 $3,500,000
Variable costs 1,150,000 1,840,000 2,300,000
Revenue before fixed costs 600,000 960,000 1,200,000
Fixed costs 650,000 650,000 650,000
EBIT -$50,000 $ 310,000 $ 550,000

(d) 10,000 units 16,000 units 20,000 units

$600,000 $960,000 $1,200,000

= -12 times = 3.1 times = 2.2
 $50,000 $310,000 $550,000
times
Notice that the degree of operating leverage decreases as the firm's sales level
rises above the break-even point.

15-4B.
(a) Durham Raleigh Charlotte
Furniture Cabinets Colonials
Sales $1,600,000 $1,957,500 $525,000
Variable costs 1,100,000 1,080,000 236,250
Revenue before
fixed costs $500,000 $877,500 $288,750
Fixed costs 40,000 150,000 60,000
EBIT $460,000 $727,500 $228,750

F $40,000 $40,000
(b) QB = = = = 6,400
PV $20.00  $13.75 $6.25
units

$150,000 $150,000
QB = $435  $240 = = 769 units
$195

$60,000
QB = = $60,000 = 3,117 units
$35.00  $15.75 $19.25

(c)

372
 Durham Raleigh Charlotte
Furniture Furniture Colonials
$500,000 $877,500 $288,750
= = =
$460,000 $727,500 $228,750

= 1.09 times 1.21 times 1.26 times

(d) Charlotte Colonials, since its degree of operating leverage exceeds that of the
other two companies.

15-5B.
(a) {S - [V + F]} (1 - T) = $55,000
V
{S – [S   + F]} (1-T) = $55,000
P
{$400,008 - [257,148 + F ]} (0.55) = $55,000
($142,860 - F) (0.55) = $55,000
F = $42,860

(b) QB = F = $42,860 = $42,860 = 4,286 units

PV $28.00  $18.00 $10.00

F
$42,860
S* = VC = = $120,056
1 1  0.643
S
15-6B. (a) Find the EBIT level at the forecast sales volume:

EBIT
= .28
S

Therefore, EBIT = (0.28) ($3,750,000) = $1,050,000

Next, find total variable costs:

VC
= 0.45,
S
so: VC = (0.45) $3,750,000 = $1,687,500
Now, solve for total fixed costs:
S - (VC + F) = $1,050,000
$3,750,000 - ($1,687,500 + F) = $1,050,000
F = $1,012,500

$1,012,500
(b) S* = = $1,840,909
1  0.45

373
15-7B.
$24,000,000
(a) = = 1.71 times
$14,000,000

EBIT $14,000,000
(b) = = 1.09 times
EBIT  I $12,850,000

(c) DCL$40,000,000= (1.71) × (1.09) = 1.86 times

F $10,000,000
(d) S* = VC = $16m
1 1
S $40m

$10,000,000 $10,000,000
= = = $16,666,667
1  0. 4 0. 6
(e) (20%) × (1.86) = 37.2%

15-8B. Given the data for this problem, several approaches are possible for finding the
break-even point in units. The approach below seems to work well with students.

Step (1) Compute the operating profit margin:

(Operating Profit Margin) x (Operating Asset Turnover) = Return on
Operating Assets
(M) x (5) = 0.25
M = .05

Step (2) Compute the sales level relative to the given output level:
Sales
= 5
$18,000,000

Sales = $90,000,000

Step (3) Compute EBIT:

(.05) ($90,000,000) = $4,500,000

Step (4) Compute revenue before fixed costs. Since the degree of operating
leverage is 6 times, revenue before fixed costs (RBF) is 6 times EBIT
as follows:
RBF = (6) ($4,500,000) = $27,000,000

374
 Step (5) Compute total variable costs:
(Sales) - (Total variable costs) = $27,000,000
$90,000,000 - (Total variable costs) = $27,000,000
Total variable costs = $63,000,000

Step (6) Compute total fixed costs:

RBF - Fixed costs = $4,500,000
$27,000,000 - fixed costs = $4,500,000
Fixed costs = $22,500,000

Step (7) Find the selling price per unit, and the variable cost per unit:
$90,000,000
P = = $12.86
7,000,000
$63,000,000
V = = $9.00
7,000,000

Step (8) Compute the break-even point:

QB = F = $22,500,000
PV ($12.86)  ($9)

$22,500,000
= = 5,829,016 units
$3.86

15-9B.
(a) QB = F = $550,000 = $550,000 = 15,715
PV $175  $140 $35
units
F $550,000
(b) S* = VC = $140
1 1
S $175
$550,000 $550,000
= = = $2,750,000
1  0. 8 .2

(c) 12,000 15,000 20,000

Units Units Units
Sales $2,100,000 $2,625,000 $3,500,000
Variable costs 1,680,000 2,100,000 2,800,000
Revenue before fixed costs $ 420,000 $ 525,000 $700,000
Fixed costs 550,000 550,000 550,000
EBIT -$130,000 -$25,000 $ 150,000

375
 (d) 12,000 units 15,000 units 20,000 units
$420,000 $525,000 $700,000
= -3.2 times = -21 times = 4.67
$  130,000  $25,000 $150,000
times

15-10B.
(a) Farm City Empire Golden
Seeds Sod Peaches
Sales $1,800,000 $1,710,000 $1,400,000
Variable costs 1,410,000 1,305,000 950,000
Revenue before fixed costs $390,000 $ 405,000 $ 450,000
Fixed costs 30,000 110,000 33,000
EBIT $ 360,000 $ 295,000 $ 417,000

(b) Farm City: QB = F = $30,000 = $30,000 = 9,231

PV $15.00  $11 .75 $3.25
units
$110,000 $110,000
Empire Sod: QB = = = 2,444 units
$190  $145 $45
$33,000 $33,000
Golden Peaches: QB = = = 3,667 units
$28.00  $19 $9
(c) Farm City Empire Golden
Seeds Sod Peaches
$390,000 $405,000 $450,000
= 1.083 times = 1.373 times = 1.079 times
$360,000 $295,000 $417,000

(d) Empire Sod, since its degree of operating leverage exceeds that of the other
two companies.

15-11B.
(a) {S – [V + F]} (1-T) = $38,000
V
{S – [S   + F]} (1-T) = $38,000
P
[($420,002) - ($222,354) - F] (0.65) = $38,000
($197,648 - F) (0.65) = $38,000
F = $139,186.46

376
 (b) QB = F = $139,186.46 = 17,398 units
PV $8
F
$139,186.46
S* = VC = = $295,766
1 1  0.5294
S

15-12B.
(a) {S – [V + f]} (1 – T) = $70,000
V
{S – [S   + F]} (1 – T) = $70,000
P
[ ($2,500,050) - (1,933,372) - F ] (.55) = $70,000
($566,678 - F) (.55) = $70,000
($311,672.9 - .55F) = $70,000
F = $439,405.27

(b) QB = F = $439,405.27 = 25,847 units

PV $17
F
$439,405.27 $439,405.27
S* = VC = =
1 1  .7733 .2267
S

= $1,938,552.66

15-13B.
(a) S (1 - 0.8) - $335,000 = $270,000
0.2S = $605,000
S = $3,025,000 = (P × Q)

Now, solve the above relationship for P:

175,000 (P) = $3,025,000
P = $17.29
(b) Sales $3,025,000
Less: Total variable costs 2,420,000
Revenue before fixed costs $605,000
Less: Total fixed costs 335,000
EBIT $ 270,000

377
15-14B.
(a) S (1-.75) - $300,000 = $250,000
.25S = $550,000
S = $2,200,000 = (P × Q)
Solve the above relationship for P:
190,000 (P) = $2,200,000
P = $11.58

(b) Sales $2,200,000

Less: Total variable costs 1,650,000
Revenue before fixed costs $550,000
Less: Total fixed costs 300,000
EBIT $ 250,000

15-15B.
(a) First, find the EBIT level at the forecast sales volume:
EBIT
= 0.25
S

So: EBIT = (0.25) $4,250,000 = $1,062,500

Next, find total variable costs:
= 0.6
So: VC = (0.60) $4,250,000 = $2,550,000
Then, solve for total fixed costs:
S - (VC + F) = $1,062,500
$4,250,000 - ($2,550,000 + F) = $1,062,500
F = $637,500

(b) S* = $637,500 = $1,593,750

1  0.6

15-16B.
(a) QB = F = $200,000 = 1,600 units
PV $125
F
$200,000
(b) S* = 1  VC = = $760,000
1  0.7368
S

378
 6,000($475  $350)
(c) DOL$2,850,000 =
6,000($475  $350)  $200,000
$750,000
= 1.364 times
$550,000

(d) (13%) x (1.364) = 17.73%

15-17B.
(a) QB = F = $55,000 = $55,000 = 5,000 units
PV $28  $17 $11
F $55,000
$55,000 $55,000
(b) S* = VC = $17 = = =
1 1 1  0.607 .393
S $28
$140,000
(c) 4,000 units 6,000 units 8,000 units
Sales $112,000 $168,000 $224,000
Variable costs 68,000 102,000 136,000
Revenue before fixed costs $ 44,000 $ 66,000 $ 88,000
Fixed costs 55,000 55,000 55,000
EBIT -$11,000 $ 11,000 $ 33,000

(d) 4000 units 6000 units 8000 units

$44,000 $66,000 $88,000
= -4X = 6X = 2.67X
 $11,000 $11,000 $33,000

(e) The degree of operating leverage decreases as the firm's sales level rises
above the break-even point.

15-18B. Compute the present level of break-even output:

QB = F = $135,000 = 19,286 units
PV $13  $6
Compute the new level of fixed costs at the break-even output:
S–V–F=0
($13) (19,286) - ($5) (19,286) - F = 0
$250,718 - $96,430 - F = 0
$154,288 = F

Compute the addition to fixed costs:

$154,288 - $135,000 = $19,288 addition

379
 40,000($13  $6)
15-19B. DOL$520,000 =
40,000($13  $6)  $135,000
$280,000
= = 1.93 times
145,000

Any percentage change in sales will magnify EBIT by a factor of 1.93.

15-20B.
50,000($13  $6)
(a) DOL$650,000 =
50,000($13  $6)  135,000
$350,000
= = 1.63 times
$215,000
$215,000
(b) DFL$215,000 = = 1.39 times
$215,000  $60,000
50,000 ($13  $6)
(c) DCL$650,000 =
50,000 ($13  $6)  $135,000  $60,000
$350,000
= = 2.26 times
$155,000
Alternatively:
DOLS x DFLEBIT = DCLS
1.63 x 1.39 = 2.26 times

15-21B. The task is to find the break-even point in units for the firm. Several
approaches are possible, but the one presented below makes intuitive sense to
students.

Step (1) Compute the operating profit margin:

(Operating Profit Margin) x (Operating Asset Turnover) = Return on
Operating Assets
(M) x (6) = 0.16
M = 0.0267

Step (2) Compute the sales level associated with the given output level:
Sales
= 6
$3,250,000

Sales = $19,500,000

Step (3) Compute EBIT:

(0.0267) ($19,500,000) = EBIT = $520,000

380
 Step (4) Compute revenue before fixed costs. Since the degree of operating
leverage is 9 times, revenue before fixed costs (RBF) is 9 times EBIT
as follows:
RBF = (9) ($520,000) = $4,680,000

Step (5) Compute total variable costs:

Sales - Total variable costs = $4,680,000
$19,500,000 - Total variable costs = $4,680,000
Total variable costs = $14,820,000

Step (6) Compute total fixed costs:

RBF - Fixed costs = $520,000
$4,680,000 - Fixed costs = $520,000
Fixed costs = $4,160,000

Step (7) Find the selling price per unit, and the variable cost per unit:
$19,500,000
P = = $11.471
1,700,000
$14,820,000
V = = $8.718
1,700,000

Step (8) Compute the break-even point:

F $4,160,000 $4,160,000
QB = = ($11 .471)  ($8.718) = =
PV $2.753
1,511,079 units

15-22B. Compute the present level of break-even output:

QB = F = $375,000 = 31,250 units
PV $25  $13

Compute the new level of fixed costs at the break-even output.

S–V–F=0
($25) (31,250) - ($11) (31,250) - F = 0
$437,500 = F

Compute the addition to fixed costs:

$437,500 - $375,000 = $62,500 addition

15-23B.
Revenue before fixed costs $4,250,000
(a) = = 3.4 times
EBIT $1,250,000
EBIT $1,250,000
(b) = = 1.25 times
EBIT  I $1,000,000

(c) DCL$13,750,000 = (3.4) × (1.25) = 4.25 times

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 F 3,000,000
(d) S* = VC = $9.5m
1 1
S $13.75m
$3,000,000 $3,000,000
= = = $9,705,597
1  0.6909 0.3091

15-24B.
Revenue before fixed costs $11,000,000
(a) = = 2.2 times
EBIT $5,000,000
EBIT $5,000,000
(b) = = 1.54 times
EBIT  I $3,250,000

(c) DCL$18,000,000 = (2.2) × (1.54) = 3.39 times

(d) (15%) × (3.39) = 50.8%
F $6,000,000
(e) S* = VC = $7m
1 1
S $18m
$6,000,000
= = $9,819,967
1  0.389

15-25B. A B C D Total
Sales $38,505 $61,995 $29,505 $19,995 $150,000
Variable costs* 23,103 42,157 23,604 7,998 96,862
Contribution margin $15,402 $19,838 $ 5,901 $ 11,997 $ 53,138
Contribution margin ratio 40% 32% 20% 60% 35.43%
*Variable costs = (Sales) (1 - contribution margin ratio)
Break-even point in sales dollars:
F $35,000
S* = 1  VC = 1  .960682 = $98,799
S 150,000

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15-26B. A B C D Total
Sales $49,995 $62,505 $25,005 12,495 $150,000
Variable costs* 29,997 42,503 20,004 4,998 97,502
Contribution margin $19,998 $20,002 $ 5,001 $ 7,497 $ 52,498
Contribution margin ratio 40% 32% 20% 60% 35%
*Variable costs = (sales) (1- contribution margin ratio).
Break-even point in sales dollars:
F
$35,000
S* = 1  VC = = $100,000
0.35
S

Wayne's management would prefer the sales mix identified in problem 15-25B.
That first sales mix provides a higher EBIT ($18,138 vs. $17,498) and a lower
break-even point ($98,799 vs. $100,000).

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