Chapter 10
Managerial Accounting
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
 More sensitive to changes in sales
 More risk
 Higher proportions of variable costs compared
to fixed costs
 Less sensitive to changes in sales
 Less risk
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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.
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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
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
Company A’s cost structure leads to a larger
increase in net operating income.
Profit Increase
$7,000 or
38.88%
Profit Increase
$4,900 or
27.22%
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Operating Leverage
 Relates to the proportional level of fixed
versus variable costs in a firm’s 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
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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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