What is operating leverage?

2.2. Operating leverage and CVP considerations

Operating leverage effects such cost-volume-profit (CVP) considerations as contribution margin, break-even sales, and margin of safety.

Contribution margin ratio:

Contribution margin is the difference between sales and variable costs. To calculate the contribution margin ratio, we can use the following formula:

Contribution Margin Ratio = 

Contribution Margin

Sales

High operating leverage means low variable costs and high contribution margin while low operating leverage means high variable costs and low contribution margin. Thus, we would expect HOL Company to have a high contribution margin ratio and LOL Company to have a low contribution margin ratio, at the same level of sales.

   

HOL Company

LOL Company

(1)

Contribution margin

$75,000

$30,000

(2)

Sales

$100,000

$100,000

(1) ÷ (2)

Contribution margin ratio

0.75

0.30

This means that HOL Company ̶ with every dollar of sales  ̶  generates 75 cents of contribution margin while LOL Company generates only 30 cents. This shows that HOL Company’s profit is more sensitive to the changes in sales revenue while LOL Company’s profit is more stable, in relation to the changes in sales.

Break-even point:

To calculate break-even sales, we can use the following formula:

Break-even Sales = 

Fixed Costs

Contribution Margin Ratio

High operating leverage means high fixed costs while low operating leverage means low fixed costs. Thus, we would expect a higher and a lower break-even point for HOL Company and LOL Company, respectively.

   

HOL Company

LOL Company

(1)

Fixed costs

$60,000

$15,000

(2)

Contribution margin ratio

0.75

0.30

(1) ÷ (2)

Break-even point

$80,000

$50,000

As we can see from the table above, HOL Company needs to generate $80,000 in sales to break even while LOL Company only needs $50,000.  HOL Company needs $30,000 more in sales than LOL Company before it breaks even: this makes HOL Company riskier than LOL Company.

Margin of safety:

To calculate the margin of safety ratio, we can use the following formula:

Margin of Safety Ratio = 

Actual Sales – Break-even Sales

Actual Sales

Because a high operating leverage requires greater break-even sales, we would expect a lower margin of safety for a company with the high operating leverage, and vice versa. Thus, we would expect a lower margin of safety for HOL Company and a higher margin of safety for LOL Company, at the same level of sales.

     

HOL Company

LOL Company

(1)

 

Actual sales

$100,000

$100,000

(2)

 

Break-even sales

80,000

50,000

(3)

(1) – (2)

Margin of safety

$20,000

$50,000

(4)

(3) ÷ (1)

Margin of safety ratio

0.2

0.5

As we can see from the table above, LOL Company could sustain a 50% decline in sales before it would be operating at a loss while HOL Company can only sustain a 20% decline. Thus, HOL Company is more vulnerable to downturns than LOL Company: HOL Company’s income is more volatile.

Even though a higher operating leverage means a higher risk, it is not necessarily a bad thing. Both high and low operating leverages have their adventures and disadvantages. High operating leverage offers better opportunities for profits (i.e., when sales increase) while low operating leverage offers greater stability and protection from losses (i.e., when sales decrease).

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