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Log Co has an operating gearing ratio of 33.33%. Its sales are currently 100m and its operating profit is 20m. Operating gearing is calculated by dividing fixed costs by variable costs. What will its operating profit be if its sales increase by 15%. The answer is 26m.
Please John, can you help in explaining the above answer. I can’t understand from the answers given in the book. Thanks
If the sales are 100m and the profit is 20m, then the total costs must be 80m.
For every $3 of variable costs, the fixed costs are $1 (33/33%) and so a total of $4.
Therefore the variable costs must be 3/4 x 80m = 60, and the fixed costs must be 1/4 x 80 = 20m.
The current contribution = 100 – 80 = $40.
If sales increase by 15% the contribution will increase to 40 + (15% x 40) = 46m, and therefore the profit will be 46 – 20 = 26m.
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