Leverage: Analysis of Operating Change
valve to its product line. The valve would be used by manufacturers of
irrigation equipment. The company anticipates starting with a relatively low
sales volume and then boosting demand over the next several years. A new
salesperson must be hired because Consolidated’s current sales force is working
at capacity. Two compensation plans are under consideration.
Plan A: An annual salary of $22,000 plus a 10% commission
based on gross dollar sales.
Plan B: An annual salary of $66,000 and no commission.
Consolidated Industries will purchase the valve for $50 and
sell it for $80. Anticipated demand the first year is 6,000 units. (Ignore
income tax)
1. Compute the break even point for plan A and B.
2. What does operating leverage mean?
3. Analyze the costs structures of both plans at the
anticipated demand of 6,000 units. Which of the two plans has a higher
operating leverage factor?
4. Assume that a general economic downturn occurred during
year 2, with product demand falling from 6,000 to 5,000 units. Determine the
percentage decrease in company net income if Consolidated had adopted Plan A.
5. Repeat question 4 but substitute for Plan B. Compare the
results and explain a major factor that underlies any resulting differences.
6. Briefly discuss the likely profitability impact of an
economic recession for highly automated manufacturers. What can you say about
the risks associated with these firms?
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