5.4: Operating leverage

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Operatying leverage is the degree to which a company can increase operating income by increasing sales. It looks at the relationship between the contribution margin and operating income. The difference between those two amounts is fixed costs.

The following is a comparative income statement for two companies.

	ABC Co.	XYZ Co.
Sales	$500,000	$500,000
Variable costs	400,000	400,000
Contribution margin	$100,000	$100,000
Fixed costs	80,000	50,000
Operating income	$20,000	$50,000

In this example, sales, total variable costs, and contribution margin are the same for both companies. ABC Co. has higher fixed costs, so as a result, it also has lower operating income.

A company’s operating leverage is determined as follows.

$\ \text{Operating leverage} =\frac{\text { Contribution margin }}{\text { Operating income }}$

		ABC Co.	XYZ Co.
Operating leverage	$\ =\frac{\text { Contribution margin }}{\text { Operating income }}$	$\ \frac{\$ 100,000}{\$ 20,000}=5$	$\ \frac{\$ 100,000}{\$ 50,000}=2$

Operating leverage results are used to determine the effect on a change in sales on operating income. The percent increase (decrease) in sales is multiplied by the operating leverage to find the percent increase (decrease) in operating income. The higher the operating leverage, the more impact a change in sales will have on operating income.

In the example, both companies had sales of $500,000. An increase of 20%, or $100,000, to $600,000 in sales would affect each of the two companies’ operating income as follows.

ABC Co.	20% x 5 = 100% increase in operating income	($20,000 x 100% = $20,000
XYZ Co.	20% x 2 = 40% increase in operating income	($50,000 x 40% = $20,000 additional)

An increase of 20% in sales to $600,000 brings operating income for ABC Co. from $20,000 to $40,000, a 100% increase. The operating income of XYZ Co. increases from $50,000 to $70,000, or 40%.

	$500,000 in sales		$600,000 in sales
	ABC Co.	XYZ Co.	ABC Co.	XYZ Co.
Sales	$500,000	$500,000	$600,000	$600,000
Variable costs	400,000	400,000	480,000	480,000
Contribution margin	$100,000	$100,000	$120,000	$120,000
Fixed costs	80,000	50,000	80,000	50,000
Operating income	$20,000	$50,000	$40,000	$70,000