Operating Leverage ACG 4361 4-3 Prepared by Diane Tanner University of North Florida 4-3

Cost Structure What is cost structure? 2 Cost Structure What is cost structure? The relative proportion of fixed and variable costs in an company If a company has a higher proportion of fixed costs compared to variable costs More sensitive to changes in sales Fixed costs are more difficult to eliminate if necessary to cut costs If a company has a higher proportion of variable costs compared to fixed costs Less sensitive to changes in sales

Comparing Cost Structures Income statements from two profitable companies appear below: Company A Company B Sales $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 Cost structures with higher fixed costs are more risky compared to those with lower fixed costs

Cost Structure Effect on Sales Increase 4 Company A 10% Sales Increase Sales $130,000 $143,000 Less variable expenses 60,000 66,000 Contribution margin 70,000 77,000 Less fixed expenses 52,000 Net operating income $ 18,000 $ 25,000 Company A Profit Increase $7,000 or 38.88% Company B Company B 10% Sales Increase Sales $130,000 $143,000 Less variable expenses 81,000 89,100 Contribution margin 49,000 53,900 Less fixed expenses 31,000 Net operating income $ 18,000 $ 22,900 Profit Increase $4,900 or 27.22% Company A’s cost structure leads to a larger increase in net operating income.

Degree of Operating Leverage A measure of how sensitive net operating income is to percentage changes in sales A risk indicator Contribution Margin Net Operating Income Degree of Operating Leverage = A higher degree of operating leverage arises when a company has a higher proportion of fixed costs, which implies higher operating risk due to higher fluctuations of profit and loss when sales fluctuates.

Degree of Operating Leverage 6 DOL = Contribution Margin Net Operating Income Company A Sales $130,000 Less variable expenses 60,000 Contribution margin 70,000 Less fixed expenses 52,000 Net operating income $ 18,000 Company A $70,000 $18,000 = 3.89 times Company B Company B Sales $130,000 Less variable expenses 81,000 Contribution margin 49,000 Less fixed expenses 31,000 Net operating income $ 18,000 $49,000 $18,000 = 2.72 times

Predictable Changes in Profit 7 DOL = 3.89 Company A Sales $130,000 Less variable costs 60,000 Contribution margin 70,000 Less fixed expenses 52,000 Net operating income $ 18,000 Company A % Change in Profit = 3.89 × 10% = 38.90% $ Change in Profit = 38.90% × $18,000 = $7,002 New Profit = Profit with 10% sales increase $25,000 $18,000 + $7,002 = $25,002 DOL = 2.72 % Change in Profit = Company B Sales $130,000 Less variable costs 81,000 Contribution margin 49,000 Less fixed expenses 31,000 Net operating income $ 18,000 Company B 2.72 × 10% = 27.20% $ Change in Profit = 27.20% × $18,000 = $4,896 New Profit = $18,000 + $4,896 = $22,896 Profit with 10% sales increase $22,900

The End