What is operating leverage?
2. Operating leverage analysis
Let’s look at a simple example. Let’s 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 companies’ 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 |
Let’s see if our predictions are correct.