Stateline Berry Farm harvests early-season blueberries for shipment throughout Michigan and Illinois in July. The strawberry farm is maintained by a permanent staff of 10 employees and seasonal workers who pick and pack the blueberries. The blueberries are sold in crates containing 100 individually packaged one-quart containers. Affixed to each one-quart container is the distinctive Stateline Berry Farm logo inviting buyers to "Enjoy the berry best blueberries in the world!" The selling price is $90 per crate, variable costs are $80 per crate, and fixed costs are $280,000 per year. In the year 2017, Stateline Berry Farm sold 50,000 crates.

Required:
a. Determine the company’s 2017 operating leverage
b. Calculate the percentage change in profit if sales decrease by 10 percent.
c. Management is considering the purchase of several berry-picking machines. This will increase annual fixed cost of $375,000 and reduce variable costs to $77.50 per crate. Calculate the effect of this acquisition on operating leverage and explain any change.

a) 2.27

b) 22.73% reduction

c) 2.5

Explanation:

a) Operating leverage is calculated by the following formula,

= Contribution Margin / Net Operating Income.

Contribution Margin is Sales - Variable costs which is,

= (90 - 80) * 50,000 units.

= $500,000

Net Income is,

= Sales - Variable Costs - Fixed assets.

We already have Sales - Variable costs so net income would be,

= 500,000 - 280,000

= $220,000

Calculating Operating Leverage we have

= 500,000/220,000

= 2.27

b) Sales Decrease by 10%

= 50,000 units ( 1 - 10%)

= 45,000 units.

Net Income would thus become,

= (90*45,000) - (80*45,000) - 280,000

= 4,050,000 - 3,600,000 - 280,000

= 170,000

Percentage change is,

= (220,000 - 170,000) / 220,000 * 100%

= 22.73%

c) Variable costs become $77.50 and fixed assets become $375,000.

New calculation of Operating Leverage will become,

Contribution Margin = Sales - Variable cost

= (90 - 77.50) * 50,000 units

= $625,000

Net Income is,

= 625,000 - 375,000

= $250,000

Operating Leverage = 625,000/250,000

= 2.5

The Operating Leverage increased. This is because the Contribution Margin rose as a result of fixed costs being less. Fixed costs rose as well but at a lesser rate than the drop in the Variable costs which ultimately meant that the numerator (Contribution Margin) rose more than the denominator ( net income).

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