Analyzing operating leverage Ken Ritch is a venture capitalist facing two alternative investment opportunities. He intends to invest $1 million in a start-up firm. He is nervous, however, about future economic volatility. He asks you to analyze the following financial data for the past year’s operations of the two firms he is considering and give him some business advice.
Variable Cost per Unit (a)
Sales Revenue (10,000 units $16)
Variable Cost (10,000 units a)
a. Use the contribution margin approach to compute the operating leverage for each firm.
b. If the economy expands in coming years, Hayden and Mauldin will both enjoy a 10 percent per year increase in sales, assuming that the selling price remains unchanged. Compute the change in net income for each firm in dollar amount and in percentage. (Note. Since the number of units increases, both revenue and variable cost will increase.)
c. If the economy contracts in coming years, Hayden and Mauldin will both suffer a 10 percent decrease in sales volume, assuming that the selling price remains unchanged. Compute the change in net income for each firm in dollar amount and in percentage. (Note. Since the number of units decreases, both total revenue and total variable cost will decrease.)
d. Write a memo to Ken Ritch with your analyses and advice.