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# Operating Leverage:

## Definition and Explanation:

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.

## Formula:

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

## Example:

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.

## Review Problem:

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:

1. Calculate degree of operating leverage at present level of sales.

2. 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.

3. 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.

## Relevant Articles:

 » Contribution Margin » Contribution Margin Ratio (CM Ratio) » Contribution Margin Income Statement » Break-even Point Analysis » Target Profit Analysis » Margin of Safety (MOS) » Operating Leverage » Break even Analysis with Multiple Products » CVP Consideration in Cost Structure » Importance of Cost Volume Profit (CVP) Analysis

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