What is operating leverage?

2. Operating leverage analysis

Letís look at a simple example. Letís assume that HOL Company and LOL Company (i.e., fictitious entities) have the same level of sales and the same net operating income but different fixed and variable costs. HOL Company has a high operating leverage while LOL Company has a low operating leverage. We have the following information about the companies:

 

HOL Company

LOL Company

Amount

%

Amount

%

Sales

$100,000

100

$100,000

100

Variable expenses

(25,000)

25

(70,000)

70

Contribution margin

75,000

75

30,000

30

Fixed expenses

(60,000)

 

(15,000)

 

Net operating income

$15,000

 

$15,000

 

To compare operating leverage across companies, we can use the following ratios (non-exhaustive list):

  • Degree of operating leverage: contribution margin divided by net income
  • Contribution margin ratio: contribution margin divided by sales
  • Break-even point (in dollars): fixed costs divided by contribution margin ratio
  • Margin of safety: the different between actual and break-even sales divided by actual sales

Based on the companiesí cost structure and operating leverage, we would expect the following results for HOL Company and LOL Company:

 

HOL Company

LOL Company

Degree of operating leverage

High

Low

Contribution margin ratio

High

Low

Break-even point (in dollars)

High

Low

Margin of safety

Low

High

Letís see if our predictions are correct.

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