Operating Leverage:
Contents:
-
Definition
and explanation
-
Formula
-
Example
-
Review problem
Operating leverage is a measure of how sensitive
net operating income is to percentage change in
sales. Operating leverage is high near the break
even point and decreases with the increase in sales
and profit. With a high operating leverage, a small
percentage increase in sales can produce a much
larger percentage increase in net operating income.
The
degree of operating leverage (DOL) is a measure,
at a given level of sales of how a percentage change
in sales volume will effect profits.
The
degree of operating leverage (DOL) at a given level
of sales is calculated by the following formula:
Degree
of operating leverage (DOL) = Contribution margin /
Net operating income
|
If two
companies have the same total revenue and same total
expenses but different cost structures, then the
company with the higher proportion of fixed costs in
its cost structure will have higher operating
leverage and the company with higher proportion of
variable cost will have low operating leverage.
Consider the following two income statements of two
different companies with different cost structures.
First
Income Statement
|
|
Company A |
Company B |
|
Amount |
Percent |
Amount |
Percent |
Sales |
$100,000 |
100% |
$100,000 |
100% |
Less
variable expenses |
60,000 |
60% |
30,000 |
30% |
|
|
|
|
|
Contribution margin |
40,000 |
40% |
70,000 |
70% |
|
|
|
|
|
Less fixed
expenses |
30,000 |
|
60,000 |
|
|
|
|
|
|
Net
operating income |
$10,000 |
|
$10,000 |
|
|
|
|
|
|
|
|
|
|
|
Second
Income Statement
|
|
Company
A |
Company
B |
|
Amount |
Percent |
Amount |
Percent |
Sales |
$110,000 |
100% |
$110,000 |
100% |
Less
variable expenses |
66,000 |
60% |
33,000 |
30% |
|
|
|
|
|
Contribution margin |
44,000 |
40% |
77,000 |
70% |
|
|
|
|
|
Less fixed
expenses |
30,000 |
|
60,000 |
|
|
|
|
|
|
Net
operating income |
14,000 |
|
17,000 |
|
|
|
|
|
|
The
data presented above belongs to company A and
company B. Company A has high variable cost and low
fixed cost where as company B has low variable cost
and high fixed cost. Note that in
first income
statement sales volume is $100,000 for both the
companies and in second income statement the sale
volume is 110,000 for both the companies i.e. a 10%
increase in sales volume. But look at the net
operating income of both the companies in second
income statement. Company A has 40% increase in net
operating income and company B has 70% increase in
net operating income. The reason is that company B
has a greater portion of fixed cost in its cost
structure than that of company A.
Calculation of Degree of operating leverage for both
the companies:
Company A = $40,000 / $10,000 = 4
Company B = $70,000 / $10,000 = 7
Percent Increase in Net Operating Income:
Company A = 10% × 4 = 40%
Company B = 10% × 7 = 70%
Since
the DOL of company A is 4 the company's net
operating income grows four times as fast as its
sales. Similarly company B's operating income grows
7 times as fast as its sales. The degree of
operating leverage is not a constant. It is greatest
at sales level near the break even point and
decreases as sales and profit rise. This
can be seen from the tabulation below, which shows
the DOL for company A at various levels of sales.
Data used earlier for company A is shown in red
color.
Sales |
$75,000 |
$80,000 |
$100,000 |
$150,000 |
225,000 |
Less
variable expenses |
45,000 |
48,000 |
60,000 |
90,000 |
135,000 |
|
|
|
|
|
|
Contribution margin |
30,000 |
32,000 |
40,000 |
60,000 |
90,000 |
Less fixed
expenses |
30,000 |
30,000 |
30,000 |
30,000 |
30,000 |
|
|
|
|
|
|
Net
operating income |
$0 |
$2,000 |
$10,000 |
$30,000 |
$60,000 |
|
|
|
|
|
|
Degree of
operating leverage |
∞ |
16 |
4 |
2 |
1.5 |
|
|
|
|
|
|
Thus a
10% increase in sales would increase profits by 15%
(10%× 1.5) if the company were operating at a
$225,000 sales level, as compared to the 40%
increase we computed earlier at the $100,000 sales
level. The DOL will continue to decrease further as
the company moves from its break even point. At the
break even point, the degree of operating leverage
is infinitely large ($30,000 contribution margin ÷
$0 net operating income = ∞).
Importance / Significance and Use of DOL:
A manager can use the DOL to quickly estimate what
impact various percentage changes in sales will have
on profits, without the necessity of preparing
detailed income statements. As shown by our example,
the effect of operating leverage can be dramatic. If
a company is near its break even point, then even a
small percentage increases in sales can yield large
percentage in profits. This explains why
management will often work very hard for only a
small increase in sales volume. If the DOL is 5,
then a 6% increase in sales would translate into a
30% increase in profits.
Voltar
Company manufactures and sells a telephone answering
machine. The company's contribution format income
statement for the most recent year is given below:
|
Total |
Per Unit |
Sales |
$1,200,000 |
$60 |
Less
variable expenses |
900,000 |
45 |
|
|
|
Contribution margin |
300,000 |
15 |
|
|
|
Less fixed
expenses |
240,000 |
|
|
|
|
Net
operating income |
60,000 |
|
|
|
|
Management is anxious to improve the company's
profit performance
Required:
-
Calculate degree of operating leverage at
present level of sales.
-
Assume that through a more intense effort by the
sales staff the company's sales increase by 8%
next year. By what percentage would you expect
net operating income to increase? Use the
operating leverage concept to obtain your
answer.
-
Verify your answer by preparing a new income
statement showing an 8% increase in sales.
Solution to Review Problem:
1. |
Degree of
operating leverage = Contribution margin
/ Net operating income
= $300,000 / $60,000
= 5 |
2. |
Expected
increase in sales = 8%
Degree of operating leverage = 5
Expected increase in net operating
income = 8% × 5 = 40%
Expected increase in net operating
income in dollars = 60,000 × 40% =
$24,000 |
3. |
If sales
increase by 8%, than 21,600 units
[20,000 + (920,000 × 8%)] will be sold
next year. The new income statement will
be as follows: |
|
|
|
Total |
Per unit |
Percent of
sales |
Sales |
$1,296,000 |
$60 |
100% |
Less variable
expenses |
972,000 |
45 |
75% |
|
|
|
|
Contribution
Margin |
324,000 |
15 |
25% |
|
|
|
|
Less fixed
expenses |
240,000 |
|
|
|
|
|
|
Net operating
income |
84,000 |
|
|
|
|
|
|
Thus, the $84,000 expected net operating income for
next year represents a 40% increase over the $60,000
net operating income earned during the current year:
($84,000 – $60,000) / $60,000
$24,000 / $60,000
40% increase
Note from the
income statement above that the increase in sales
from 20,000 units to 21,600 units has resulted in
increase in both total sales and total variable
expenses. It is a common error to overlook the
increase in variable expenses when preparing a
projected income statement.
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