Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 36

Operating Leverage These sales and cost data (000s) are for two companies in the transportation industry:

	Company A		Company B
	Amount	Percent of sales	Amount	Percent of sales
Sales	$100,000	100%	$100,000	100%
Variable costs	60,000	60	30,000	30
Contribution margin	$ 40,000	40%	$ 70,000	70%
Fixed costs	15,000		40,000
Operating profit	$ 25,000		$ 30,000

Required

1. Calculate the operating leverage for each company. If sales increase, which company benefits more? How do you know?

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2. Assume that sales rise 10 percent in the next year. Calculate the percentage increase in profit for each company. Are the results what you expected?

Step 1 of 2

1.?operating leverage =   contribution margin 

                                           operating profit

A's operating leverage = $40,000/$25,000 = 1.6

B's operating leverage = $70,000/$30,000 = 2.3333

If sales increase, company B will benefit more. Company B has a higher proportion of fixed costs in relation to variable costs; therefore it has a higher operating leverage than does Company A. The degree of operating leverage is a measure, at a specific level of sales, of how a percentage change in sales volume will affect profits. The higher the operating leverage, the more sensitive profits are to changes in sales volume.