Fin_200_Break_Even_Analysis

The Watson Corporation sells spools of thread to industrial clothing suppliers. They sell 25 pound spools of thread for $150 each. The Watson Corporation’s fixed costs are $200,000 and the variable costs are $2 per pound. a. What is the break-even point in units (spools of thread)' BE = Fixed Costs = Fixed Costs = FC Contribution Margin Price - Variable Cost per Unit P - VC $200,000 = $200,000 = 2000 units $150 - $50 $100 b. Calculate the profit or loss on 1,500 and 3,000 spools of thread. 1,500 spools Revenue = Units * Price per Unit 1,500 * $150 = $225,000 Total Cost = Fixed Costs + Variable Costs $200,000 + (1,500 * $50) = $200,000 + $75,000 = $275,000 Revenue - Total Cost = Profit or Loss $225,000 - $275,000 = ($50,000) Income Loss 3,000 spools Revenue = Units - Price per Unit 3,000 * $150 = $450,000 Total Cost = Fixed Costs + Variable Costs $200,000 + (3,000 * $50) = $200,000 + $150,000 = $350,000 Revenue - Total Cost = Profit or Loss $450,000 - $350,000 = $100,000 Profit c. What is the degree of operating leverage at 2,500 spools' And 3,000 spools' Why does the degree of operating leverage change as the quantity sold increases' DOL = Q(P - VC) Q(P - VC) - PC 2,500 spools 3,000 spools DOL = 2,500 ($150 - $50) DOL = 3,000 ($150 - $50) 2,500 ($150 - $50) - $200,000 3,000 ($150 - $50) - $200,000 = 2,500 ($100) = 3,000 ($100) 2,500 ($100) - $200,000 3,000 ($100) - $200,000 = $250,000 = $300,000 $250,000 - $200,000 $300,000 - $200,000 DOL = 5 DOL = 3 The Degree of Leverage decreases the farther away you move from the break-even point because the cost of operating income increases due to the production of more product. d. If the Watson Corporation has anannul interest expense of $20,000. Calculate the degree of financial leverage at both 2,500 spools and 3,000 spools. DFL = EBIT EBIT - 1 2,500 spools 3,000 spools DFL = $50,000 DFL = $100,000 $50,000 - $20,000 $100,000-$20,000 = $50,000 = $100,000 $30,000 $80,000 DFL = 1.67 DFL = 1.25 e. What is the degree of combine leverage at both sales levels' DCL = Q(P - VC) Q(P - VC) - FC - 1 2,500 spools 3,000 spools DCL = 2,500 ($150 - $50) DCL = 3,000 ($150 - $50) 2,500 ($150 - $50) - $200,000 - $20,000 3,000 ($150 - $50) - $200,000 - $20,000 = 2,500 ($100) = 3,000 ($100) 2,500 ($100) - $180,000 3,000 ($100) - $180,000 = $250,000 = $300,000 $250,000 - $180,000 $300,000 - $180,000 = $250,000 = $300,000 $70,000 $120,000 DCL = 3.57 DCL = 2.5 f. Briefly (in ten to fifteen sentences) explain the differences, between the degree of operating leverage the degree of financial leverage, and the degree of combined leverage. What should each be used for' The degree of operating leverage, financial leverage, and combined leverage may use some of the same information to determine their leverage amounts but they all serve their own purpose. The degree of operating leverage (DOL) is used to determine the percentage amount of income received verses the the amount of units sold. The percentage amount lets the financial manager know what percentage of their income is actually profit. The only time the DOL should be used to compute the income percentage when operations have been profitable. The more product that is produced and sold the less profit the company will make because of the increase in operations. The DOL represents the asset section of the balance where as the degree of financial leverage (DFL) represents the liabilities and net worth section of the balance sheet. The DFL is used to determine the percentage of debt the company uses in the structure of its capital. Lenders use this information to determine the rate of interest they should charge the company when asking for a loan. However, stock prices may be driven down if there interest rate is too high and restrictions are placed on the company. The DOL and DFL influence different sections of the income statement, where as the degree of combined leverage (DCL) utilizes the entire income statement. The DCL combines the DOL and the DFL and this information shows how changes in sales impact the company's eanings per share. The DCL should only be used if the company's overall desire is to show a balance between its DFL and its DOL.