Operating Leverage

Operating leverage refers to the extent to which a company uses fixed costs in its cost structure. If a company has a relatively high proportion of fixed costs relative to its variable costs, then it has the potential for generating large percentage increase in net income from a relatively small increase in sales revenue.

1. In your words, describe operating leverage and how it might be useful to you.

2 How would you describe the operating leverage of your current or previous employer? If you do not have work experience to draw upon, then answer this question in terms of a particular industry, e.g., banking, manufacturing, health-care, education, government, etc.

3. If you were to go into your own business, what mix of fixed and variable costs do you think you would prefer? Why?

Exercise

Company A is a manufacturer with current sales of $6,000,000 and a 60% contribution margin. Its fixed costs equal $2,600,000. Company B is a consulting firm with current service revenues of $4,500,000 and a 25% contribution margin. Its fixed costs equal $375,000. Compute the degree of operating leverage (DOL) for each company. Identify which company benefits more from a 20% increase in sales and explain why.