CMA Study Group

Explain how OP leverage increased

  • 1.  Explain how OP leverage increased

    Posted 23 days ago
    Since incorporating 3 years ago, a company has estimated bad debts at a rate of 3% using the income statement approach. During its fourth year in business, after recording the uncollectible accounts expense based on its previous estimate, the company determined that its estimate of bad debts should be increased to 4.5%. During this fourth year, the company recorded sales of $25,000,000 and had an ending accounts receivable balance of $2,000,000. This change would decrease
    Answer (A) is correct.
    The company increased its bad debt expense by 1.5% for the current year. This increase would cause a decrease in income of $375,000 [25,000,000 × (4.5% – 3%)]. Because the company used the income statement approach of calculating bad debts, the accounts receivable balance of $2,000,000 is irrelevant. This decrease in income will cause both the numerator (contribution margin) and the denominator (operating income) of the firm's operating leverage to decrease by a proportional amount. However, this proportional decrease will cause the overall leverage to increase.

    Tayba Al-Mehdar
    Saudi Arabia