CONCEPT AND BENEFIT OF OPERATING

LEVERAGE AND ITS PRACTICAL

APPLICABILITY

BY

HARSH AGRAWAL

ROLL NO.22
 CONTENT

Operating leverage

1. Computation of operating leverage

2. Interpretation of operating leverage

Practical applicability of operating leverage

3. Conclusion
.

OPERATING LEVERAGE
Operating leverage:

 It is the extent to which a firm uses FIXED COST in producing its

goods or offering its services.

 It is a MEASURE of how sensitive is to % changes in sales to %

change in Net operating Income.

 Operating leverage acts as a multiplier.
 If operating leverage is high, a small percentage increase in sales can

produce a much larger percentage increase in net operating income.

 It is high near the break even point and decreases as the sales and

profit increase.

Fixed costs means the cost which do not change with the change in number
of units produced or number units services are offered and includes

(i) Advertising expenses,

(ii) Administrative costs (like rent, salary of official staff)

(iii) Depreciation

(iv) Taxes,

But not INTEREST ON DEBT, which is part of financial leverage.

 By using fixed production costs, a company can increase its profits.

Company with large % of fixed costs, has a high degree of operating

leverage.

Illustration on Operating Leverage

Firm A uses a highly automated production process with robotic machines,
whereas firm B assembles the widgets using primarily semiskilled labor.

FIRM A FIRM B
Automated Labor Intensive
Variable Cost 1.00 per unit 3.00 per unit

Sales (Qty) 10000 10000

Sale Price per Pcs 5 5
Sales in Rs 50000 50000
Variable Cost 10000 30000
Contribution 40000 20000

Fixed Cost 35000 15000

EBIT 5000 5000

8 4
Operating Leverage =40000/5000 =20000/5000

Firm A

 Higher amount of operating leverage because of its higher fixed costs

 Higher breakeven point—the point at which total costs equal total

sales. Nevertheless, a change of I percent in sales causes more than a I

percent change in operating profits for firm A, but not for firm B. The
"degree of operating leverage" measures this effect.

Operating leverage is a double-edged sword, however. If firm A's sales

decrease by I percent, its profits will decrease by more than I percent, too.
Hence, the degree of operating leverage shows the responsiveness of profits
to a given change in sales.

COMPUTATION OF OPERATING LEVERAGE

1. Degree of operating leverage. 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 at a given level
of sales is computed as follows:

2.The math underlying the degree of operating leverage. The degree of

operating leverage can be used to estimate how a given percentage change in
sales volume will affect net income at a given level of sales, assuming there
is no change in fixed expenses. To verify this, consider the following:

=
=

= Percentage change in net operating income

Thus, providing that fixed expenses are not affected and the other assumptions
of CVP analysis are valid, the degree of operating leverage provides a quick
way to predict the percentage effect on profits of a given percentage increase in
sales. The higher the degree of operating leverage, the larger the increase in net
operating income.

3.Degree of operating leverage is not constant. The degree of operating

leverage is not constant as the level of sales changes. For example, at the break-
even point the degree of operating leverage is infinite since the denominator of
the ratio is zero. Therefore, the degree of operating leverage should be used
with some caution and should be recomputed for each level of starting sales.

4. Operating leverage and cost structure. the relation between operating

leverage and the cost structure of the company is contingent. It is difficult, for
example, to infer the relative proportions of fixed and variable costs in the cost
structures of any two companies just by comparing their operating leverages.
We can, however, say that if two single-product companies have the same
profit, the same selling price, the same unit sales, and the same total expenses,
then the company with the higher operating leverage will have a higher
proportion of fixed costs in its cost structure. If they do not have the same
profit, the same unit sales, the same selling price, and the same total expenses,
we cannot safely make this inference about their cost structure. All of the
statements in the text about operating leverage and cost structure assume that
the companies being compared are identical except for the proportions of fixed
and variable costs in their cost structures.

Definition of Degree of Operating Leverage (DOL):

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:
INTERPRETATION OF OPERATING LEVERAGE
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 insecond 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 offixed cost in its cost
structure than that of company A.

Computation / 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 operating leverage (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.
PRACTICAL APPLICABILITY OF OPERATING LEVERAGE

Essentially, operating leverage boils down to an analysis of fixed

costs and variable costs. Operating leverage is highest in companies that
have a high proportion of fixed operating costs in relation to variable
operating costs. This kind of company uses more fixed assets in the
operation of the company. Conversely, operating leverage is lowest in
companies that have a low proportion of fixed operating costs in relation to
variable operating costs

The benefits of high operating leverage can be immense. Companies with

high operating leverage can make more money from each additional sale if
they don't have to increase costs to produce more sales. The minute business
picks up, fixed assets such as property, plant and equipment (PP&E), as well
as existing workers, can do a whole lot more without adding additional
costs. Profit margins expand and earnings soar faster than revenues.

Take, for example, a software maker such as Microsoft. The bulk of this
company's cost structure is fixed and limited to upfront development and
marketing costs. Whether it sells one copy or 10 million copies of its latest
Windows software, Microsoft's costs remain basically unchanged. So, once
the company has sold enough copies to cover its fixed costs, every
additional dollar ofsales revenue drops into the bottom line. In other words,
Microsoft possesses remarkably high operating leverage.

By contrast, a retailer, such as Wal-Mart demonstrates relatively low

operating leverage. The company has fairly low levels of fixed costs, while
its variable costs are large. Merchandise inventory represents Wal-Mart's
biggest cost. For each product sale that Wal-Mart rings in, the company has
to pay for the supply of that product. As a result, Wal-Mart's cost of goods
sold (COGS) continues to rise as sales revenues rise.

Risky Business
Operating leverage can tell investors a lot about a company's risk profile and
although high operating leverage can often benefit companies, companies
with high operating leverage are also vulnerable to sharp economic and
business cycle swings.

As stated above, in good times, high operating leverage can supercharge

profit. But companies with a lot of costs tied up in machinery, plants, real
estate and distribution networks can't easily cut expenses to adjust to a
change in demand. So, if there is a downturn in the economy, earnings don't
just fall, they can plummet.

Consider the software developer Inktomi. During the 1990s investors

marveled at the nature of its software business. The company spent tens of
millions of dollars to develop each of its digital delivery and storage
software programs. But thanks to the internet, Inktomi's software could be
distributed to customers at almost no cost. In other words, the company had
close to zero cost of goods sold. After its fixed development costs were
recovered, each additional sale was almost pure profit.

After the collapse of dotcom technology market demand in 2000, Inktomi

suffered the dark side of operating leverage. As sales took a nosedive, profits
swung dramatically to a staggering $58 million loss in Q1 of 2001 –
plunging down from the $1 million profit the company had enjoyed in Q1 of
2000. The high leverage involved in counting on sales to repay fixed costs
can put companies and their shareholders at risk. High operating leverage
during a downturn can be an Achilles heel, putting pressure on profit
margins and making a contraction in earnings unavoidable.

Indeed, companies such as Inktomi, with high operating leverage, typically

have larger volatility in their operating earnings and share prices. As a result,
investors need to treat these companies with caution.
Conclusion

We should be very careful using either of these approaches. They can be

misleading if applied indiscriminately. They do not consider a company's
capacity for growing sales. Few investors really know whether a company
can expand sales volume past a certain level without, say, sub-contracting to
third-parties or further capital investment, which would increase fixed costs
and alter operational leverage. At the same time, a company's prices, product
mix and cost of inventory and raw materials are all subject to change.
Without a good understanding of the company's inner workings, it is
difficult to get a truly accurate measure of the DOL.

Nevertheless, it worth getting even a rough idea of a company's operating

leverage. Even if it is not 100% accurate, knowledge of a company's DOL
can help us assess the level of risk it offers to investors.

Although you need to be careful when looking at operating leverage, it can

tell you a lot about a company and its future profitability. Investors can get a
rough sense of the company's outlook and risk in the face of changing
market conditions. While operating leverage doesn't tell the whole story, it
certainly can help.
Measuring Operating Leverage
Operating leverage occurs when a company has fixed costs that must be met regardless of sales volume.
When the firm has fixed costs, the percentage change in profits due to changes in sales volume is greater
than the percentage change in sales. With positive (i.e. greater than zero) fixed operating costs, a change of
1% in sales produces a change of greater than 1% in operating profit.
A measure of this leverage effect is referred to as the degree of operating leverage (DOL), which shows the
extent to which operating profits change as sales volume changes. This indicates the expected response in
profits if sales volumes change. Specifically, DOL is the percentage change in income (usually taken
as earnings before interest and tax, or EBIT) divided by the percentage change in the level of sales output.

For illustration, let's say a software company has invested $10 million into development and marketing for
its latest application program, which sells for $45 per copy. Each copy costs the company $5 to sell. Sales
volume reaches one million copies.

So, the software company enjoys a DOL of 1.33. In other words, a 25% change in sales volume would
produce a 1.33 x 25% = 33% change in operating profit.

Unfortunately, unless you are a company insider, it can be very difficult to acquire all of the information
necessary to measure a company's DOL. Consider, for instance, fixed and variable costs, which are critical
inputs for understanding operating leverage. It would be surprising if companies didn't have this kind of
information on cost structure, but companies are not required to disclose such information in published
accounts.

Investors can come up with a rough estimate of DOL by dividing the change in a company's operating
profit by the change in its sales revenue.

Looking back at a company's income statements, investors can calculate changes in operating profit and
sales. Investors can use the change in EBIT divided by the change in sales revenue to estimate what the
value of DOL might be for different levels of sales. This allows investors to estimate profitability under a
range of scenarios.

Example: Automated and high-tech companies, utility companies, and airlines

generally have high degrees of operating leverage.

. The following simplified equation demonstrates the type of equation

used to compute the degree of operating leverage, although to calculate
this figure the equation would require several additional factors such as
the quantity produced, variable cost per unit, and the price per unit,
which are used to determine changes in profits and sales: