CFA Practice Question

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CFA Practice Question

Firms A and B both produce economy automobiles for the same market. Firm A utilizes more fixed assets in its production process than does Firm B. Assuming that the market perceives their products as identical and neither firm has any pricing power, which of the following statements would be correct?

A. Firm A will have higher sales volatility than firm B.
B. Firm B will have higher operating income volatility than Firm A.
C. Firm B will have lower operating income volatility than firm A.
Correct Answer: C

The two firms should face the same sales volatility, but Firm A, which has higher fixed costs in the production function, will likely have higher operating income volatility.

User Contributed Comments 4

User Comment
swisha Doesn't make sense to me, when you have higher fixed costs wouldn't you have LESS volatility in EBIT?
nike It's exactly the opposite, swisha. higher fixed costs make you inflexible.
johntan1979 Understand the formula... the fixed costs, F is with a minus sign in the denominator, hence, increasing %change in EBIT (volatility).
ibrahim18 See it this way. If sales falls, the firm most likely would fire their employees to make profit. But when most costs are fixed, variability is sales would result in a much variability in operating income. Clear?
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