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Operating Leverage: Prepared by Diane Tanner University of North Florida

This document discusses cost structure and operating leverage. It defines cost structure as the proportion of fixed and variable costs a company has. A higher proportion of fixed costs makes a company more risky since it is more sensitive to changes in sales. The document provides an example comparing CopyDisk, which has mainly variable costs, to ZoomCopy, which has higher fixed equipment costs. It then shows how a company with a higher proportion of fixed costs, like Company A, will see greater increases but also decreases in profits compared to a company with mainly variable costs, like Company B. It introduces operating leverage as a measure of risk based on a company's cost structure, with higher operating leverage indicating higher proportion of fixed costs and more risk.

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Kanwaljit Singh Jolly
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51 views8 pages

Operating Leverage: Prepared by Diane Tanner University of North Florida

This document discusses cost structure and operating leverage. It defines cost structure as the proportion of fixed and variable costs a company has. A higher proportion of fixed costs makes a company more risky since it is more sensitive to changes in sales. The document provides an example comparing CopyDisk, which has mainly variable costs, to ZoomCopy, which has higher fixed equipment costs. It then shows how a company with a higher proportion of fixed costs, like Company A, will see greater increases but also decreases in profits compared to a company with mainly variable costs, like Company B. It introduces operating leverage as a measure of risk based on a company's cost structure, with higher operating leverage indicating higher proportion of fixed costs and more risk.

Uploaded by

Kanwaljit Singh Jolly
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Chapter 10

Operating Leverage

Prepared by Diane Tanner University of North Florida

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


Higher proportions of variable costs compared to fixed costs Less sensitive to changes in sales Less risk
More sensitive to changes in sales More risk

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

Comparing Cost Structures


Income statements from two equally profitable companies appear below:
Sales Less variable expenses Contribution margin Less fixed expenses Net operating income Company A Company B $130,000 $130,000 60,000 81,000 70,000 49,000 52,000 31,000 $ 18,000 $ 18,000

Cost structures with higher fixed costs compared to those with lower fixed are more risky

Cost Structure Effect on Sales Increase


Sales Less variable expenses Contribution margin Less fixed expenses Net operating income Company With 10% A Increase $130,000 $143,000 60,000 66,000 70,000 77,000 52,000 52,000 $ 18,000 $ 25,000

Profit Increase $7,000 or 38.88%

Company With 10% B Increase Sales $130,000 $143,000 Less variable expenses 81,000 89,100 Contribution margin 49,000 53,900 Less fixed expenses 31,000 31,000 Net operating income $ 18,000 $ 22,900

Profit Increase $4,900 or 27.22%

Company As cost structure leads to a larger increase in net operating income.

Operating Leverage
Relates to the proportional level of fixed versus variable costs in a firms 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

Measuring Operating Leverage


A measure of how sensitive net operating income is to percentage changes in sales A risk indicator
Degree of Operating Leverage Company A $70,000 = 3.89 $18,000 = Contribution Margin Net Operating Income Company B $49,000 = 2.72 $18,000

Higher degree of operating leverage indicates higher proportion of fixed costs and higher risk.

The End

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