AIM-2-17-0006-NT

OPERATING LEVERAGE
Background Note

Abstract

This background note seeks to expound the nature, procedures, and uses of
operating leverage as a business practice. It begins by explaining the cost structure of a
firm based on the behavior of costs and why fixed costs are used as a lever to generate
profit. The degree of operating leverage, used as the overall measure of the sensitivity of
profit on the change in sales, has been elaborated. This note tackles why operating leverage
is a risk indicator and how the point of indifference between two options is computed.

1.0 Cost Structure of a Firm

An organization incurs both fixed and variable costs. In fact, it can influence the
proportion of fixed and variable costs it incurs. At times, a manager has some latitude in
trading fixed costs for variable costs. Typically, firms with higher fixed costs have relatively
lower variable costs. As variable cost decreases, the contribution margin increases. The
proportion of fixed costs and variable costs incurred by a firm is known as its cost
structure.

For example, the cost structure of Company A consists of 80% variable and 20%
fixed (Table 1). This indicates that fixed cost constitutes a lesser proportion of the total
cost. On the other hand, Company B’s cost structure is 20% variable and 80% fixed.

This background note was written by Prof. Rufo R. Mendoza, PhD, CPA. Asian Institute of Management. All learning materials are
prepared solely for class discussion. This contains information gathered from secondary sources (i.e., books, journals, magazines,
newspapers, etc. and the writer’s insights based on teaching and work experience). The background note is neither designed nor
intended to illustrate the correct or incorrect management of problems or issues contained in the case.

Copyright © 2017, Asian Institute of Management, Makati City, Philippines, http://www.aim.edu. For inquiries, please contact the AIM
Knowledge Resource Center at krc@aim.edu.
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Table 1. Sample Cost Structure

Co. A Co. B
Amount % Amount %
Variable cost 400,000 80 100,000 20
Fixed cost 100,000 20 400,000 80
Total cost 500,000 100 500,000 100

Two primary concerns about cost structure are (a) why do companies increase
fixed costs? and (b) which is a better structure—high variable costs and low fixed costs, or
the opposite case of low variable costs and high fixed costs?

Organizations whose cost structure shows high fixed costs, like Company B,
normally invest in equipment, machineries, and other physical facilities that are used in
running the business. This relative amount of fixed costs may also be due to the company’s
choice of technology. Investments in equipment, machineries, and other tangible
properties generate more fixed costs, primarily in the form of depreciation. Oftentimes,
large costs tied up in these properties have relatively small amount of labor cost—which is
a variable cost. Firms that have lower variable costs and increased proportion of fixed costs
will thus benefit with greater increase in profit as sales increases. In that sense, fixed costs
are being used as a leverage to increase profit.

A manager may have some latitude in trading between fixed and variable costs. But
no categorial answer is possible as to which cost structure is better as there are advantages
for both, depending on the specific circumstances. The degree of operating leverage can
provide answers to the question regarding which cost structure is better.

2.0 The Marginal Income Statement

The marginal income statement is a variation in format of the traditional income

statement. The traditional income statement (Table 2) shows the costs and expenses by
functions: cost of sales, distribution or marketing expenses, and administrative expenses.
While both have the same income and expense contents the presentation reveals different
types of information.

Table 2. Traditional Income Statement

Sales USD100,000
Less: Cost of Sales 65,000
Gross Profit 35,000
Less: Operating Expenses
Distribution/marketing expenses 8,000
Administrative expenses 10,000
Net Operating Profit 17,000

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Two glaring features of the marginal income statement are: (1) It presents costs
and expenses based on their behavior, that is, either fixed and variable; and (2) It shows
the amount of contribution margin, also known as marginal income, which is the amount
left after variable costs are deducted from sales. The contribution margin is also the one
used to cover the fixed costs. Thus, if the contribution margin is just enough to pay for the
fixed costs, the business is said to be at a break-even point. If the contribution margin is
greater than the fixed costs, the business will achieve some profits. The business will incur
loss if the marginal income is not enough to cover the fixed costs.

The income statement above can be transformed into a marginal income statement
by classifying costs and expenses into fixed and variables. Understandably, the cost of sales
is a variable cost. Let’s assume that 50% of both the distribution and administrative
expenses are variable, the variable costs will amount to USD74,000, broken down into
USD65000 cost of sales, USD4,000 distribution expenses, and USD5,000 administrative
expenses. The marginal income statement is shown in Table 3.

Table 3. Marginal Income Statement

Sales USD100,000
Less: Variable costs 74,000
Contribution margin 26,000
Less: Fixed costs 9,000
Net Operating Profit 17,000

The marginal income statement is the one used when organizing the data necessary
to compute the break-even points and at the same time, when these data are checked. It
should be noted that variable costs change with the magnitude of sales—that is the reason
why they are called variable. On a per unit basis, the variable cost is fixed, say USD100 per
unit. If the firm can generate sales equivalent to 200 units at USD130, the sales will
amount to USD26,000 and total variable costs will amount to USD20,000. On the other
hand, fixed costs remain constant regardless of the magnitude of sales. Hence, the
contribution margin should be equal to the fixed costs to be at the break-even point.

3.0 Nature of Operating Leverage

When a firm has fixed costs, operating leverage is present1. In fact, the concept
of operating leverage originates from the existence of fixed costs that the firm must pay to
operate. Operating leverage is defined in two perspectives. First, it is defined as the extent
to which the cost structure of an organization has fixed versus variable costs 2. Yet the
concept refers to the extent to which fixed (rather than variable) costs characterize an
organization’s cost structure. The higher the proportion of fixed costs is, the higher the
operating leverage. 3 Second, operating leverage is also defined as the use of fixed costs to
extract higher percentage change in profit as sales activity changes 4. Here, fixed costs are
used as a lever to magnify profit.

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The marginal income statement in Table 4 shows two companies with the same
amount of sales and profit. The first company, Manual System Company, has higher
variable costs as a percentage of sales (67%). These costs are primarily in the form of direct
labor since the company uses a manual system of production. On the other hand, the
Automated System Company has higher fixed costs (67%) due to the automated system
that has reduced the labor components but has increased the depreciation expense on the
automated equipment.

Table 4. Comparative Marginal Income Statement

Manual System Co. Automated System Co.

Amount % Amount %
Sales 600,000 100 600,000 100
Less: Variable costs 400,000 66.67 100,000 16.67
Contribution margin 200,000 33.33 500,000 83.33
Less: Fixed costs 100,000 16.67 400,000 66.67
Net (operating) profit 100,000 16.67 100,000 16.67

The cost structure of an organization determines its operating leverage. Because

fixed costs are incurred regardless of the level of sales, organizations with higher fixed
costs find it difficult to reduce these costs in the short-run. As a result, organizations with
higher proportions of fixed costs have higher operating leverage and are considered to
have more risky operations. Companies with a cost structure consisting of significant
amounts of production labor with fewer capital assets have lower fixed costs and higher
variable costs. Variable costs are easier to reduce on a short-term basis, which in turn,
implies lower operating leverage and less risky operations.

4.0 Degree of Operating Leverage

The operating leverage can be better analyzed by determining the degree of

operating leverage (DOL), computed by the following formula:

Contribution margin
Degree of Operating Level =
Net profit

The DOL for the Manual System Co. is 2 while that of the Automated System Co.
is 5.

Manual System Co. Automated System Co.

Contribution margin 200,000 500,000
Net profit 100,000 100,000
Degree of operating leverage 2 5

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The DOL is a measure of the firm’s operating leverage. It is a measure of the

sensitivity of net profit to changes in sales. Manual System Company’s DOL of 2 indicates
that any percentage of change in sales will redound to a change in profit twice as that of
the change in sales. Thus, if the amount of sales increases by 10%, the corresponding profit
will increase by 20%. The same is true for the Automated System Company’s DOL of 5. If
the amount of sales increases by 10%, the profit will increase by 50%. It should be noted
that operating leverage is a two-edged sword. As the amount of sales decreases, the
corresponding profit also decreases.

Let us assume that both companies have generated a 10% increase in sales revenue.
Let’s see what is the effect on profit.

As shown in Table 3, the Manual System Co. has a net profit of USD120,000, or an
increase of USD20,000, representing a 20% increase. The Automated System Co. now has
a higher profit at USD150,000, or an increase of USD50,000, representing 50%.

Table 5. Comparative Marginal Income Statement with 10% Increase in Sales

Manual System Co. Automated System Co.

Sales 660,000 660,000
Variable costs 440,000 110,000
Contribution margin 220,000 550,000
Fixed costs 100,000 400,000
Net (operating) profit 120,000 150,000
Increase in profit 20,000 50,000
% increase in profit 20 50
% change in sales 10 10
Degree of operating leverage 2 5

As shown above, the DOL can alternatively be obtained by dividing the percentage
change in profit by the percentage change in sales.

% Change in Profit
Degree of Operating Level =
% Change in Sales

Mathematically, the percentage increase in profit can be simply derived by

multiplying the percentage increase in sales by the DOL as shown below.

Manual System Co. Automated System Co.

% increase in sales 10 10
Degree of operating leverage 2 5
% increase in profit 20 50

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The Automated System Co. has a higher DOL of 5. It also has a higher operating
leverage since a large proportion of the company’s costs are fixed costs. In this case, the
company earns a large profit on each incremental sale, but it must attain sufficient sales
volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major
profit on all sales after it has paid for its fixed costs.

The Manual System Co. has a lower DOL of 2. It has a lower operating leverage,
which means that a large proportion of the company’s sales are variable costs, so it only
incurs these costs if there is a sale. In this case, the firm earns a smaller profit on each
incremental sale, but does not have to generate much sales volume to cover its lower fixed
costs. It is easier for this type of company to earn a profit at low sales levels, but it does not
earn outsized profits if it can generate additional sales.

5.0 Operating Leverage as a Risk Indicator

As indicated above, the DOL measures how sensitive operating profits are to
changes in sales. It is this magnification process that captures the risk embedded in
operating leverage. As sales volume changes, so too does operating profit, both on the
upside and the downside. A high DOL means that profits are very sensitive to changes in
level of sales; a low DOL means that profits are relatively insensitive to the level of
operations. Thus, DOL relates to the concept of a business risk.

Overall, businesses operating at a high DOL enjoy profits that rise more quickly
when sales increase. But they also face a higher risk of loss when sales decreases. In fact,
the high-leverage alternative is riskier as it provides the highest possible net profit and the
highest possible losses. On the other hand, the low-leverage alternative is less risky
because variations in sales lead only to a small variability in net profit.

6.0 Determining the Indifference Point

The degree of operating leverage provides some balancing acts for the business.
And the business should choose among alternatives. Thus, it is necessary to determine the
point of indifference, also known as indifference point. The indifference point
between alternatives is the level of sales (units or dollars) where the profits of the
alternatives are equal.

For example, two alternatives are available for a business: the current plan and the
proposed plan. The data above the two alternatives are as follows:

Current Plan Proposed Plan

Contribution margin per unit $120 $90
Total fixed costs $360,000 $315,000

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The indifference point is computed as follows:

Profit (current plan) = Profit (proposed plan)

$120Q-$360,000 = $90Q-$315,000
$120Q-$90Q = $360,000-$315,000
$30Q = $45,000
Q = 1,500 units

The indifference point can also be in terms of cost as shown in the example below:

Current Proposed
Sales per unit USD1,000 USD1,000
Variable cost per unit 400 300
Contribution margin per unit 600 700
Total fixed costs USD25,000,000 USD40,000,000

The indifference point is computed as follows:

Cost Function (current) = Cost Function (proposed)

Variable cost per unit x Quantity = Variable cost per unit x Quantity
+ Fixed Costs + Fixed Costs
$400Q + $25,000,000 = $300Q + $40,000,000
$400Q-$300Q = $40,000,000-$25,000,000
$100Q = $15,000,000
Q = 150,000 units

7.0 Conclusions

From the above discussions, the following conclusions are made.

1. The higher the fixed cost percentage in the cost structure of a firm, the higher the
operating leverage. This principle implies that the variable cost is lower and the
contribution margin is higher. The firm is said to have "high operating leverage".

2. The operating leverage is further measured by the DOL, which shows the sensitivity of
profit to any increase in sales. The higher the DOL, the higher is the sensitivity of profit
to any increase in sales.

3. The DOL can be used to quickly estimate what impact various percentage changes will
have on profits, without the necessity of preparing detailed income statements. 5

4. When using the operating leverage measurement, constant monitoring of operating

leverage is more important for a firm having high operating leverage, since a small
percentage change in sales can result in a dramatic increase (or decrease) in profits. A
firm must be especially careful to forecast its revenues carefully in such situations,

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since a small forecasting error translates into much larger errors in both net income
and cash flows.

5. Knowledge of the DOL can have a profound impact on pricing policy, since a company
with a large amount of operating leverage must be careful not to set its prices so low
that it can never generate enough contribution margin to fully offset its fixed costs.

Endnotes

1 Gitman & Zutter. (2013). Principles of Managerial Finance. 13th Edition. Pearson Educational Limited. p. 565.
2 Blocher, et al. (2016). Cost Management: A Strategic Emphasis. 7th Edition. McGraw Hill Education. p. 315.
3 Ibid.
4 Hansen, D.R. & Mowen, M.M. (2015). Cornerstone of Cost Management. 3 rd Edition. South-Western Cencage

Learning. p. 847
5 Garrison, Noreen, et al. (2015). Managerial Accounting. Asia Global Edition. 2 nd Edition. McGraw Hill

Education. p. 174

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