Operating Leverage and Risk Financial statement information is presented below for Hillary Corporation, a producer of mountain climbing gear. The company expects sales to increase by about 20% in 2004.
|
(In millions) |
2003 Actual |
2004 Expected |
|
Sales |
$692 |
$830 |
|
Cost of goods sold |
462 |
554 |
|
Operating expenses |
206 |
247 |
|
Operating income |
24 |
29 |
|
Interest expense |
5 |
5 |
|
Pretax income |
19 |
24 |
|
Income taxes |
7 |
8 |
|
Net income |
$12 |
$16 |
Hillary’s management is considering automating much of the company’s production process. The automation would result in about half of the company’s cost of goods sold being fixed. Currently, most of these costs vary in proportion to sales, as shown in the financial numbers presented above.
Required
A. Assume that half ($231 million) of Hillary’s cost of goods sold in 2003 is fixed and that the other half increases in proportion to sales, an increase of 20%. Compute the company’s expected cost of goods sold.
B. Using the same assumptions as part A, compute expected net income for 2004. Assume that income taxes are 35% of pretax income. Round to the nearest million.
C. Compare your results with those presented above, which assume that cost of goods sold varies in proportion to sales. What effect would the automation have on Hillary’s profitability? What effect would it have on the company’s risk? Explain your answer.