How To Calculate Operating Leverage Essay Example

sales. The formula for DOL is: DOL = Contribution margin / Net operating income.
To illustrate this, let's look at two companies with equal total revenue and expenses but different cost structures. If one company has more fixed costs compared to another company with more variable costs, it will have higher operating leverage.
Below are the income statements for Company A and Company B that show their unique cost structures. Company A has higher variable costs and lower fixed costs, while Company B has lower variable costs and higher fixed costs.

The initial income statement indicates that both companies have a sales volume of $100,000. In the subsequent income statement, the sales volume for both companies increases to $110,000, indicating a 10% growth in sales volume. However, when comparing the net operating income in the second income statement, Company A shows a 40% increase while Company B shows a 70% increase. This difference can be attributed to Company B having a higher proportion of fixed costs compared to Company A.

The computation of the degree of operating leverage is as follows:

Company A: $40,000 / $10,000 = 4

Company B: $70,000 / $10,000 = 7

The percent increase in net operating income for Company A is calculated as 10% * 4 = 40%, while for Company B it is computed as 10% * 7 = 70%. Thus, with a degree of operating leverage of 4, Company A's net operating income grows four times faster than its sales. Similarly, with a DOL of 7, Company B's operating income grows seven times faster than its sales.

It should be noted that the degree of operating leverage varies based on sales levels and is highest near

the break-even point. As sales and profits rise, the DOL decreases. The following table illustrates the DOL for Company A at different sales levels.

The data previously used for company A is displayed in red color. Thus, if the company had $225,000 in sales, a 10% increase would result in a 15% increase in profits (10%? 1.5), compared to the previous calculation of a 40% increase with $100,000 in sales. As the company exceeds its break-even point, the degree of operating leverage (DOL) will continue to decline. At the break-even point, the DOL is infinitely large ($30,000 contribution margin ? $0 net operating income = ?). The DOL holds significance as it allows managers to easily estimate how different percentage changes in sales will affect profits without needing detailed income statements.

The example emphasizes the significant impact of operating leverage, as even a small increase in sales can result in substantial profits when a company is close to its break-even point. This is why management often puts in great effort to achieve only a slight increase in sales volume. For instance, if the degree of operating leverage (DOL) is 5, then a 6% increase in sales would lead to a 30% increase in profits. In order to improve profit performance at Voltar Company, management needs to accomplish certain tasks:
1. Calculate the current level of operating leverage (degree of operating leverage) at the present sales level.
2. Estimate the expected percentage increase in net operating income by assuming an 8% increase in sales due to a more intense effort by the sales staff next year using the concept of operating leverage.
3. Verify the answer obtained by preparing

a new income statement that reflects an 8% increase in sales.

To solve these tasks for the Review Problem:
1. Calculate Degree of Operating Leverage = Contribution margin / Net operating income = $300,000 / $60,000 = 5.
2. Apply the degree of operating leverage (5) with an anticipated 8% increase in sales to determine the expected rise in net operating income.
3. Prepare a new income statement that reflects an 8% increase in sales for task two completion and verification purposesUnderstanding and utilizing concepts like operating leverage is crucial for businesses looking to improve profitability and performance. This requires verifying the projected income statement by creating a new one that reflects an 8% increase in sales. With this expected increase in sales, net operating income would rise by 40%, equaling $24,000 (calculated as $60,000 x 40%). The projection expects sales to increase by 8%, reaching a total of 21,600 units (computed as the sum of 20,000 units plus 920,000 units multiplied by 8%). The newly created income statement shows total sales of $1,296,000 and variable expenses totaling $972,000. Consequently, the contribution margin is determined to be $324,000. After deducting fixed expenses of $240,000 from this contribution margin figure, the resulting net operating income amounts to $84,000. It's important to note that both total sales and total variable expenses increased due to the growth in sales. Overlooking this fact when constructing a projected income statement is a common mistake.