44 Operating Leverage

So you, as a manager, just got word that one of your best selling products has new competition. It is anticipated that sales will drop by 20 percent. How will that affect your net profit? Well, if you remember from our cost-volume-profit analysis, it isn’t a dollar for dollar change. It depends on a few factors.

Operating leverage can be defined as a measure of sensitivity of net income to changes in sales. In other words, sales may only go up a small amount, but it can have a large effect on our net income, depending on our variable and fixed costs..

Degree of operating leverage is a measure, at a given level of sales, of how a change in sales will affect the net profit.

The formula for operating leverage:

Degree of operating leverage=Contribution Margin/Net Operating Income

Let’s look at two companies, one who has higher variable costs and is using labor to create a product, and a second company who purchased an expensive piece of equipment to automate their manufacturing process. Both companies manufacture bicycles and their selling price per bicycle is $200. Jen’s Bike Co. pays $50 in labor and $20 in other variable costs for each bicycle made. Steve’s Bike Co. has the $20 in variable costs, but invested $250,000 in a machine that will replace the employees for 5 years, no matter how many bikes they make. Both Jen and Steve pay $50,000 a year in other fixed expenses.

In our example, each Jen and Steve sell 1000 bikes per year. At this volume, they each have a net profit of $80,000. Jen’s operating leverage is $130,00080,000=1.625″>$130,000/80,000=1.625 while Steve’s operating leverage is 2.25.

With this information, we can calculate how fast net income will rise with a certain rise in income.

% change in net operating income = degree of operating leverage x % change in sales.

So in our example, if Jen’s sales went up by 10%, she could expect an increase in net profit of 16.25%, while Steve, with the same increase in sales would show a net profit increase of 22.5%.

But what happens if there is a year where they each only sell 800 bikes instead of 1000?

Note that Jen is now making more in net profit than Steve, even though sales went down by the exact same amount. What happens to the operating leverage when the sales changes?

Jen’s operating leverage is $104,000$54,000″>$104,000/$54,000 so 1.93 and Steve’s is now $144,00044,000″>$144,000/44,000 so 3.28. Now, for each 10% rise in sales, Jen will see a 19.3% increase in net profit, while Steve will see a 32.8% rise in net profit with the same increase in sales.

Ok, now the market for bicycles tanks and each Jen and Steve have a year where they only sell 500 bicycles!

Wow! Now Steve is showing a loss. This has to do with operating leverage.

One last example here. What if the demand for bicycles goes nuts and each Jen and Steve have sales increases to 1500 bikes per year!

Now Steve, with his automated equipment has the higher net profit.

So, hopefully this helps you, as a manager, to understand how changes in sales volume affect net profit or loss, depending on the cost structure. A piece of equipment can be a great thing or it can hinder a company’s bottom line. Careful planning is needed.