Operating Leverage - Managerial Accounting - Lecture Slides, Slides of Management Accounting

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Learning Objective 13

Compute the degree of

operating leverage at a

particular level of sales

and explain how it can be

used to predict changes in

net operating income.

Operating Leverage

A measure of how sensitive net operating

income is to percentage changes in sales.

Contribution margin Net operating income

Degree of

operating leverage =

Operating Leverage

With an operating leverage of 5, if Racing increases

its sales by 10%, net operating income would

increase by 50%.

Percent increase in sales 10%

Degree of operating leverage × 5

Percent increase in profits 50%

Here’s the verification!

Operating Leverage

Actual sales (500)

Increased sales (550)

Sales $ 250,000 $ 275,

Less variable expenses 150,000 165,

Contribution margin 100,000 110,

Less fixed expenses 80,000 80,

Net operating income $ 20,000 $ 30,

10% increase in sales from

$250,000 to $275,...

... results in a 50% increase in

income from $20,000 to $30,000.

Coffee Klatch is an espresso stand in a downtown office building. The average selling price of a cup of coffee is $1.49 and the average variable expense per cup is $0.36. The average fixed expense per month is $1,300. 2,100 cups are sold each month on average. What is the operating leverage? a. 2. b. 0. c. 0. d. 2.

Quick Check 

Contribution margin Net operating income

Operating leverage = $2, = (^) $1,073 = 2.

Actual sales 2,100 cups Sales $ 3, Less: Variable expenses 756 Contribution margin 2, Less: Fixed expenses 1, Net operating income $ 1,

Quick Check 

At Coffee Klatch the average selling price of a cup of coffee is $1.49, the average variable expense per cup is $0.36, the average fixed expense per month is $1,300 and an average of 2,100 cups are sold each month.

If sales increase by 20%, by how much should net operating income increase?

a. 30.0% b. 20.0% c. 22.1% d. 44.2%

Verify Increase in Profit

Actual sales

Increased sales 2,100 cups 2,520 cups

Sales $ 3,129 $ 3,

Less: Variable expenses 756 907

Contribution margin 2,373 2,

Less: Fixed expenses 1,300 1,

Net operating income $ 1,073 $ 1,

% change in sales 20.0%

% change in net operating income 44.2%

Structuring Sales Commissions

Companies generally compensate

salespeople by paying them either a

commission based on sales or a salary plus a

sales commission. Commissions based on

sales dollars can lead to lower profits in a

company.

Let’s look at an example.

Structuring Sales Commissions

If you were on the sales force at Pipeline, you would

push hard to sell the Turbo even though the XR

earns a higher contribution margin per unit.

To eliminate this type of conflict, commissions can

be based on contribution margin rather than on

selling price alone.