1. Operating Leverage Managerial Accounting Prepared by Diane Tanner University of North Florida Chapter 10

2. 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 2

3. 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? 3 ZoomCopy is more risky, because its additional equipment will generate more depreciation, a fixed cost. ZoomCopy is more risky, because its additional equipment will generate more depreciation, a fixed cost.

4. Comparing Cost Structures Income statements from two equally profitable companies appear below: 4 Company ACompany 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 compared to those with lower fixed are more risky

5. Cost Structure Effect on Sales Increase Company A’s cost structure leads to a larger increase in net operating income. 5 Company A With 10% Increase Sales$130,000$143,000 Less variable expenses60,00066,000 Contribution margin70,00077,000 Less fixed expenses52,000 Net operating income$ 18,000$ 25,000 Profit Increase $7,000 or 38.88% Profit Increase $7,000 or 38.88% Company B With 10% Increase Sales$130,000$143,000 Less variable expenses81,00089,100 Contribution margin49,00053,900 Less fixed expenses31,000 Net operating income$ 18,000$ 22,900 Profit Increase $4,900 or 27.22% Profit Increase $4,900 or 27.22%

6. 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 6

7. 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 7 Degree of Operating Leverage = Contribution Margin Net Operating Income

8. 8 The End