Lincoln Lodging Inc.estimates that if its sales increase 10.00% then its net income will increase 14.50%.The company's EBIT equals $2.4 million,and its interest expense is $400,000.The company's operating costs include fixed and variable costs.What is the level of the company's fixed operating costs? Do not round your intermediate calculations.
A) $480,000
B) $455,000
C) $400,000
D) $500,000
E) $420,000

Question

Quizplus · Accepted Answer

Using the formula for degree of operating leverage (DOL):
DOL = % change in net income / % change in sales
DOL = 14.50% / 10.00%
DOL = 1.45

DOL = (contribution margin / EBIT)
1.45 = (contribution margin / $2,400,000)
contribution margin = $3,480,000

contribution margin = (sales - variable costs)
$3,480,000 = (sales - variable costs)

Assuming variable costs are a constant percentage of sales, we can solve for fixed costs using the following equation:

Fixed costs = EBIT - interest expense - (net sales x variable cost percentage)
Fixed costs = $2,400,000 - $400,000 - (1.10x x 0.694x)
(where x = current level of sales)

Solving for x:
$3,080,000 - 0.764x = 0
x = $4,030,366.49

Plugging x into the equation for fixed costs:
Fixed costs = $2,400,000 - $400,000 - ($4,030,366.49 x 0.694)
Fixed costs = $2,400,000 - $400,000 - $2,795,291.17
Fixed costs = $205,708.83

Therefore, the level of fixed operating costs is $205,708.83, which is closest to answer choice D ($500,000).