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

2. 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

3. 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

4. Cost Structure Effect on Sales Increase4
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.

5. 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.

6. Degree of Operating Leverage6
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

7. Predictable Changes in Profit7
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

8. The End