Operating Leverage..... Definition and Formula

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Operating Leverage

Operating leverage can be measured if the breakdown of fixed cost and variable cost in a company’s operating structure is known. Operating leverage is normally based upon operating income to avoid muddying the signal with financial leverage or taxes. Computing operating leverage would be easy if the proportion of fixed and variable costs could be known with certainty. Consider a stylized example:

Operating leverage is computed by dividing the contribution margin (revenues less variable costs) by the operating income. In this case, operating leverage is 1.50 (300/200). So, a 10% increase in revenues should yield a 15% increase in operating income (10% * 1.5). As seen above, a 20% increase in sales yielded a 30% increase in operating income. Since our example had no interest expense, there is no financial leverage and the increase in taxes and net income was also 30%. The company benefits from operating leverage as it grows since fixed costs do not increase and existing fixed costs are “spread” across higher revenues. As a percentage of revenues, the fixed costs shrink. Of course operating leverage will also work against the firm if revenues fall since fixed costs do not fall accordingly. In fact, in our stylized example, if revenue were to fall by 20%, operating income would fall by 30%. Operating leverage also does not remain constant; it must be recomputed each period as the relationships among contribution margin, fixed costs, and operating income change. Statistical techniques such as regression analysis can be useful for this purpose. A shortcut method of approximating operating leverage is to divide the change in operating income by the change in sales: Percentage Change in Operating Income

Percentage Change in Revenues

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:

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 ACompany B
Less variable expenses60,00060%30,00030%
Contribution margin40,00040%70,00070%
======= =======
Less fixed expenses30,000 60,000
-------- -------
Net operating income$10,000 $10,000
====== ======

Second Income Statement

Company ACompany B
Less variable expenses66,00060%33,00030%
Contribution margin44,00040%77,00070%
====== ======
Less fixed expenses30,000 60,000
--------- --------
Net operating income14,000 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...
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