This chapter examines how a company's cost structure can affect its profitability and its operating risk. This relationship is measured as operating leverage which assesses how sensitive a company's operating income is to a change in sales. Understanding this concept is helpful to managers because they need to anticipate how a change in revenue will affect operating income. It also helps managers see how external users view their company.

 


Cost Structure


To determine a company's degree of operating leverage, you must examine its cost structure. Cost structure refers to the proportion of fixed costs incurred by a company in relation to the amount of variable costs it incurs. Companies with large costs tied up in production equipment will often have relatively small amounts of assembly labor costs. While investments in machinery generate depreciation—a fixed cost, fewer production employees result in lower labor costs—which are variable. Because fixed costs are incurred regardless of the level of sales, companies with higher fixed costs find it difficult to reduce these costs in the short-run. As a result, companies with higher proportions of fixed costs have higher operating leverage and are considered to have more risky operations. Companies with a cost structure consisting of significant amounts of production labor with fewer capital assets have lower fixed costs and higher variable costs. Variable costs are easier to reduce on a short-term basis, which in turn, implies lower operating leverage and less risky operations.

 


Measuring Operating Leverage


Assume two companies have maintained relatively the same amount of revenue and the same amount of operating profit for the past two years, and that both companies experience a 15 percent increase in sales revenue during the current year. The change in operating income for each of the two companies will differ depending on each company’s degree of operating leverage.

 

There are two components of operating leverage---contribution margin and operating income. The higher the contribution margin is, the more quickly profits increase with sales. This results because high contribution margin amounts have lower variable costs in proportion to total costs. Operating income typically consists of ‘income before interest and income taxes.’ However, companies that experience more complex income components may require adjustments to the basic operating income amount to be used in the calculation.

 

A company's degree of operating leverage (DOL) is calculated by dividing the amount of contribution margin by the amount of operating income.

 

Degree of operating leverage =

Contribution margin

Operating income

The DOL amount is unique in that the calculated amount typically carries no label, such as a dollar or percentage sign. Labeling DOL as ‘times’ is acceptable.

 


Interpreting the Degree of Operating Leverage


The DOL indicates the number of times that the contribution margin exceeds the company’s operating income. A company with higher DOL has more extreme fluctuations in operating income than a company with a lower DOL when a change in sales revenue occurs. A high DOL implies a more risky operating structure because of the volatility of the change in profit. Conversely, a lower DOL amount implies a less risky operating structure. The following table summarizes the relationship between cost structure, risk, profit fluctuations, and the degree of operating leverage.

Suppose Marsh Company has a contribution margin of $495,000 and operating income of $110,000. Its DOL is $495,000 divided by $110,000, or 4.50. The DOL of 4.50 indicates that each dollar increase in sales revenue is expected to generate a $4.50 increase in profit. In isolation, the DOL does not provide much insight. However, as a comparison with prior periods or against other companies, the DOL enables managers and investors to evaluate a company’s operating risk. If Marsh's DOL was 3.4 the prior year, we can conclude that Marsh is becoming more risky since its DOL has risen.

 


Using the Degree of Operating Leverage to Predict Operating Income


The DOL can be used to predict the effect that a specified increase in sales will have on operating income. One approach to determine the effect is to prepare a revised income statement that reflects the increase in sales, though time consuming and unnecessary. Using the operating leverage approach, you can quickly estimate the percentage change in operating income by multiplying the DOL by the anticipated percentage change in sales. Assuming that Marsh Company’s sales are expected to increase by 10 percent, the expected change in operating income is:

 

Percentage increase in operating income: 4.50 x 10% = 45.00%

 

The 45.00% change represents the 'increase' in operating income due to a 10% increase in sales. To determine the dollar change in profit, multiple the percentage change in operating income times the original profit of $110,000:

 

Dollar change in operating income = 45.00% x $110,000 = $49,500

 

Operating income is expected to increase by $49,500 if sales increase by 10%. To determine the estimated new profit level as a result of the change, add the original profit to the increase.

 

Estimated new operating income level = $49,500 + $110,000 = $159,500

 

Marsh Company’s profit after a 15.00% sales increase is estimated at $159,500. Note that a similar effect occurs if revenue is expected to decline. In this case, the dollar decrease in operating income will be subtracted from the original operating income instead of adding to determine the new estimated income.

 


Why Does Profit Change More Than Sales?


The greater the percentage of fixed costs in a company's structure, the greater the increase/decrease in operating income from a stated percentage increase or decrease in revenue. Operating leverage is higher near the breakeven point and decreases with an increase in sales. This is because once a company reaches its breakeven point, every unit sold thereafter contributes directly to an increase in profit, as sales up to the breakeven point have already covered fixed costs. Once a company with a higher proportion of fixed costs reaches breakeven, each sales dollar beyond breakeven generates a higher contribution to profit. A company with lower fixed costs, results in a lower contribution out of each sales dollar once breakeven has been achieved.

 


The Risk Element


Companies with a higher DOL are more risky because profit is more volatile, i.e., more likely to change. This can be favorable for managers and investors due to a specified change in sales producing higher earnings in a company with high operating leverage. However, on the flip side, managers and investors will see a larger decline in profit if the company has high operating leverage than if the company has a lower DOL. 

 

For example, the 45% change in Marsh Company’s operating income is expected to generate an estimated increase of operating income of $49,500. This is great news for managers and investors. However, the monetary change is the same regardless if revenue increases or decreases. A 10% decline in Marsh Company’s revenue is expected to generate a 45% decrease in profit resulting in an estimated $49,500 profit decline, to a new profit level of $60,500.

 

New estimated profit = $110,000 – $49,500 = $60,500

 

The new profit of $60,500 is substantially less than the original profit of $110,000 and will result in a big disappointment to managers, creditors, and investors. While a higher degree of operating leverage causes revenue increases to favorably impact profit, it also causes revenue declines to have a negative impact on profit or result in an operating loss.

 

Managers need to know how investors perceive their company in terms of operating leverage. Investors often compare potential stock investments with competitors to assess which company is the less risky. More conservative investors will likely choose to invest in companies that maintain a lower DOL, which aggressive investors may prefer investments in companies with higher DOLs because of the larger return these companies will generate if sales increase. 

 

Once identified, managers have some ability to reduce their company's operating leverage risk by reducing fixed costs, often by offsetting with an increase in variable costs. This is sometimes accomplished through outsourcing. An increase in variable costs also increases forecasting accuracy because variable costs are more predictable.

 


Walk Through Problem


Income information for Spring Company is presented below for the current year:

 

Sales revenue

$550,000

Variable costs

220,000

Fixed costs

 210,000

Operating income

$120,000

 

Use the operating leverage approach to determine the amount by which Spring Company’s operating income will change if sales decline by 26%.

Solution

Step 1: Determine the degree of operating leverage:

 

DOL =

Contribution margin

=

$550,000 - $220,000

=

2.75

Operating income

$120,000

 

The DOL indicates that for every $1 decrease in sales revenue, Spring Company will experience a $2.75  decrease in operating income.

 

Step 2: Use the DOL to determine the percentage change in operating income by multiplying it by the 26% percentage change expected.

2.75 x 26% = 71.5%

Spring will experience a 71.5% decrease in profit if its sales decrease by 26%.

 

Step 3: Determine the new operating income assuming the 26% decrease in revenue. The new operating income will be:

$120,000 - [71.5% x $120,000] = $34,200

Spring Company's new operating income will be $34,200 if sales revenue declines by 26%. To prove the calculation, you can prepare an income statement which reflects the 26% decrease in sales. Original sales of $550,000 is multiplied by 74%, or 100.00% - 26%, to determine the new sales of $407,000. Variable costs will decline by the same percentage: 74% times $220,000 arrives at the new variable cost of $162,800. Because fixed costs in total do not change when sales activity levels change, we hold fixed costs at $210,000. Subtracting both fixed and variable costs from sales revenue arrives at the adjusted operating income at $34,200, as proved in this income statement:

 

Sales revenue

$407,000

Variable costs

162,800

Fixed costs

210,000

Operating Income

$  34,200


This page was last edited on Wednesday January 06, 2010 03:01 PM
Website designed and maintained by dtanner@unf.edu
Copyright © 1999-2015. University of North Florida. All rights reserved.