Operating leverage measures the risk-return tradeoff across alternative cost structures. Operating leverage describes the effects that fixed costs have on changes in operating income as changes occur in units sold and contribution margin. Organizations with a high proportion of fixed costs in their cost structures, as is the case with Option 1, have high operating leverage. The line representing Option 1 in Exhibit 3-5 is the steepest of the three lines. Small increases in sales lead to large increases in operating income. Small decreases in sales result in large decreases in operating income and greater risk of losses. At any given level of sales,
The following table shows the degree of operating leverage at sales of 40 units for the three rental options.
The table depicts the contribution margin per unit, contribution margin (row 1 times 40 units), operating income (from Exhibit 3-5), and degree of operating leverage (row 2 divided by row 3) for three rental options. The details of the table are as follows:
Contribution margin per unit
Option 1: 80 dollars
Option 2: 50 dollars
Option 3: 30 dollars
Contribution margin (row 1 times 40 units)
Option 1: 3,200 dollars
Option 2: 2,000 dollars
Option 3: 1,200 dollars
Operating income (from Exhibit 3-5)
Option 1: 1,200 dollars
Option 2: 1,200 dollars
Option 3: 1,200 dollars
Contribution margin per unit
Option 1: 3,200 dollars divided by 1,200 dollars equals 2.67
Option 2: 2,000 dollars divided by 1,200 dollars equals 1.67
Option 3: 1,200 dollars divided by 1,200 dollars equals 1.00
These results indicate that, when sales are 40 units, a 1% change in sales and contribution margin will result in 2.67% change in operating income for Option 1 and a 1% change in operating income for Option 3. Consider, for example, a sales increase of 50% from 40 to 60 units. Contribution margin will increase by 50% under each option (from $3,200 to in Option 1 and from $2,000 to in Option 3). Operating income, however, will increase by from $1,200 to $2,800 in Option 1, but it will increase by only from $1,200 to $1,800 in Option 3 (see Exhibit 3-5). The degree of operating leverage at a given level of sales helps managers calculate the effect of sales fluctuations on operating income.
Keep in mind that, in the presence of fixed costs, the degree of operating leverage is different at different levels of sales. For example, at sales of 60 units, the degree of operating leverage under each of the three options is as follows:
The degree of operating leverage decreases from 2.67 (at sales of 40 units) to 1.71 (at sales of 60 units) under Option 1 and from 1.67 to 1.36 under Option 2. In general, whenever there are fixed costs, the degree of operating leverage decreases as the level of sales increases beyond the breakeven point. If fixed costs are $0 as they are in Option 3, contribution margin equals operating income and the degree of operating leverage equals 1.00 at all sales levels.
It is important for managers to monitor operating leverage carefully. Consider companies such as General Motors and American Airlines. Their high operating leverage was a major reason for their financial problems. Anticipating high demand for their services, these companies borrowed money to acquire assets, resulting in high fixed costs. As sales declined, they suffered losses and could not generate enough cash to service interest and debt, causing them to seek bankruptcy protection. Managers and management accountants must manage the level of fixed costs and variable costs to balance the risk-return tradeoff.
What can managers do to reduce fixed costs? Nike, the shoe and apparel company, does no manufacturing and incurs no fixed costs of operating manufacturing plants. Instead, it outsources production and buys its products from suppliers in countries such as China, Indonesia, and Vietnam. As a result, all of Nike’s production costs are variable costs. Nike reduces its risk of loss by increasing variable costs and reducing fixed costs.
Companies that continue to do their own manufacturing are moving their facilities from the United States to lower-cost countries, such as Mexico and China, to reduce both fixed costs and variable costs. Other companies, such as General Electric and Hewlett-Packard, have shifted service functions, such as after-sales customer service, to their customer call centers in countries such as India. These decisions by companies are often controversial. Some economists argue that outsourcing or building plants in other countries helps keep costs, and therefore prices, low and enables U.S. companies to remain globally competitive. Others argue that outsourcing and setting up manufacturing in other countries reduces job opportunities in the United States and hurts working-class families.
