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Operating Leverage

Managerial Accounting

Prepared by Diane TannerUniversity of North Florida

Chapter 10

Cost Structure and Risk

• What is cost structure?– The relative proportion of fixed and variable

costs in an company• Higher proportions of fixed costs compared to

variable costs–More sensitive to changes in sales–More risk

– Higher proportions of variable costs compared to fixed costs• Less sensitive to changes in sales– Less risk

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Cost Structure Example

CopyDisk and ZoomCopy are both in the business of reproducing mass quantities of DVDs. CopyDisk

depends on hourly workers to insert disks into the copier, while ZoomCopy uses costly equipment that automatically inserts DVDs to be copied. As a result,

ZoomCopy has higher fixed costs compared to its total costs, while CopyDisk has proportionally higher variable

costs. Which cost structures is more risky?

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ZoomCopy is more risky, because its additionalequipment will generate more depreciation, a fixed cost.

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Comparing Cost Structures

Income statements from two equally profitable companies appear below:

Company A Company BSales $130,000 $130,000 Less variable expenses 60,000 81,000 Contribution margin 70,000 49,000 Less fixed expenses 52,000 31,000 Net operating income $ 18,000 $ 18,000

Cost structures with higher fixed costs compared to those with

lower fixed are more risky

Cost Structure Effect on Sales Increase

Company A’s cost structure leads to a larger increase in net operating income.

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Company A

With 10% Increase

Sales $130,000 $143,000Less variable expenses 60,000 66,000Contribution margin 70,000 77,000Less fixed expenses 52,000 52,000Net operating income $ 18,000 $ 25,000

Profit Increase$7,000 or 38.88%

Company B

With 10% Increase

Sales $130,000 $143,000Less variable expenses 81,000 89,100Contribution margin 49,000 53,900Less fixed expenses 31,000 31,000Net operating income $ 18,000 $ 22,900

Profit Increase$4,900 or 27.22%

Operating Leverage

Relates to the proportional level of fixed versus variable costs in a firm’s cost structure

General rules The higher the degree of fixed costs

The more operating leverage a company has

The more risk a company possesses Creating greater profit and loss swings

as sales increase or decrease

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Measuring Operating Leverage

Higher degree of operating leverage indicates higher proportion of fixed costs and higher risk.

A measure of how sensitive net operating income is to percentage changes in sales

A risk indicator

$70,000$18,000

= 3.89 $49,000$18,000

= 2.72

Company A Company B

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Degree of Operating Leverage

= Contribution MarginNet Operating Income

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The End