Week 3 Lab 1 Question: Genatron Wants To Estimate What Will

Week3_Lab1 Question: Genatron wants to estimate what will happen to its

Genatron seeks to project its income before interest and taxes (EBIT) based on potential changes in net sales from the 2012 level of $1,500,000. The exercise involves calculating the expected EBIT for both a 10 percent decrease and a 10 percent increase in net sales. The provided 2012 income statement details EBIT at $247,000, with cost of goods sold (COGS) considered variable expenses and all other operating expenses fixed. The analysis requires understanding how sales fluctuations impact EBIT, considering the variable and fixed costs, and subsequently determining the degree of operating leverage (DOL).

The detailed data from the 2012 income statement includes net sales, COGS, gross profit, operating expenses, interest, and taxes, which will serve as the basis for calculations.

Paper For Above instruction

Introduction

Understanding the relationship between sales volume and profitability is vital for effective financial management and planning. The concept of operating leverage plays a crucial role in this analysis, as it measures how sensitive a company's operating income is to changes in sales. This paper explores how to estimate the impact of a 10 percent change in net sales on Genatron's income before interest and taxes (EBIT), considering the fixed and variable components of its cost structure, and determines the degree of operating leverage involved.

Analysis of Sales Impact on EBIT

Based on the 2012 income statement, Genatron's net sales were $1,500,000, with a COGS of $900,000. Since the COGS are treated as variable expenses, they will scale directly with sales. The fixed expenses include general and administrative expenses, marketing, and depreciation, totaling $150,000, $15,000, and $3,000 respectively, summing up to $168,000.

To project EBIT for a 10% decrease and increase in sales, establish the initial contribution margin per dollar of sales:

Contribution margin = Net sales - Variable costs (COGS)

At the 2012 sales level:

• Contribution margin = $1,500,000 - $900,000 = $600,000
• Contribution margin ratio = $600,000 / $1,500,000 = 0.4 (40%)

Next, calculate the projected sales figures:

• 10% decrease in sales: $1,500,000 x 0.9 = $1,350,000
• 10% increase in sales: $1,500,000 x 1.1 = $1,650,000

Using the contribution margin ratio, the contribution margin at these levels is:

• Decreased sales contribution margin: $1,350,000 x 0.4 = $540,000
• Increased sales contribution margin: $1,650,000 x 0.4 = $660,000

Now, derive the EBIT by subtracting fixed costs:

Fixed operating expenses are total fixed expenses fixed at $168,000 (sum of G&A, marketing, depreciation).

Therefore, projected EBIT for both scenarios:

• 10% decrease: $540,000 - $168,000 = $372,000
• 10% increase: $660,000 - $168,000 = $492,000

Determining Percentage Change and Degree of Operating Leverage

The percentage change in EBIT from the baseline ($247,000 at $1,500,000 sales) to the projected EBITs is calculated as follows:

• For 10% decrease in sales: ((\$372,000 - \$247,000) / \$247,000) x 100 = approximately 50.6%
• For 10% increase in sales: ((\$492,000 - \$247,000) / \$247,000) x 100 = approximately 99.6%

Now, compute the degree of operating leverage (DOL), which indicates how a change in sales impacts EBIT:

DOL = Percentage change in EBIT / Percentage change in sales

Since sales changed by 10%, the DOL in both cases is approximately:

• 50.6% / 10% = 5.06 for the decrease
• 99.6% / 10% = 9.96 for the increase

These results imply that EBIT is highly sensitive to sales variations, particularly in this scenario, with a DOL nearing 5 during sales decline and nearly 10 when sales increase.

Conclusion

The analysis demonstrates that Genatron's EBIT responds significantly to fluctuations in sales due to its cost structure, characterized by fixed operating costs and variable COGS. The calculated degree of operating leverage indicates a substantial operational risk but also a potential for increased profitability with higher sales. Entrepreneurs and managers should consider these drivers for strategic planning, cost control, and sales growth initiatives.

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