{"id":85,"date":"2021-01-26T22:02:43","date_gmt":"2021-01-26T22:02:43","guid":{"rendered":"https:\/\/courses.lumenlearning.com\/wm-managerialaccounting\/?post_type=chapter&#038;p=85"},"modified":"2021-05-12T22:55:24","modified_gmt":"2021-05-12T22:55:24","slug":"operating-leverage","status":"publish","type":"chapter","link":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/chapter\/operating-leverage\/","title":{"raw":"Operating Leverage","rendered":"Operating Leverage"},"content":{"raw":"<div class=\"textbox learning-objectives\">\r\n<h3>Learning Outcomes<\/h3>\r\n<ul>\r\n \t<li>Calculate operating leverage<\/li>\r\n<\/ul>\r\n<\/div>\r\n<strong><img class=\"size-medium wp-image-1571 alignleft\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5469\/2021\/01\/12225446\/ashley-byrd-KVby0S0GaH4-unsplash-1-200x300.jpg\" alt=\"Books on display\" width=\"200\" height=\"300\" \/>Operating leverage<\/strong> represents the relationship between the contribution margin and operating income: the difference between those two amounts is fixed costs. The ratio measures the degree to which a company can increase its operating income by increasing sales.\r\n\r\nOperating leverage = contribution margin\/operating income\r\n\r\nIn other words, operating leverage predicts the effect of a change in sales on operating income. The percent increase (decrease) in sales is multiplied by the operating leverage to find the percent increase (decrease) in operating income. The higher the operating leverage, the more impact a change in sales will have on operating income.\r\n\r\nLet\u2019s compute the operating leverage for BlankBooks, Inc. at a sales level of 2,900 units:\r\n<div align=\"left\">\r\n<table class=\"fin-table acctstatement fw\"><caption>BlankBooks, Inc.\r\nCVP Analysis - current production\r\nFor the month ending July 31, 20XX<\/caption>\r\n<tbody>\r\n<tr>\r\n<th class=\"r\" scope=\"col\"><\/th>\r\n<th class=\"r\" scope=\"col\">Units<\/th>\r\n<th class=\"r\" scope=\"col\">$\/Unit<\/th>\r\n<th class=\"r\" scope=\"col\">Total<\/th>\r\n<\/tr>\r\n<\/tbody>\r\n<tbody>\r\n<tr>\r\n<td>Sales<\/td>\r\n<td class=\"r\">2,900<\/td>\r\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a010.00<\/td>\r\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a029,000.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Variable costs<\/td>\r\n<td class=\"r\">2,900<\/td>\r\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a08.30<\/td>\r\n<td class=\"r\">24,070.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Contribution Margin<\/td>\r\n<td><\/td>\r\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01.70<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>4,930.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Fixed costs<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td class=\"r\">\u00a0\u00a0\u00a0\u00a0\u00a0\u00a03,400.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Operating income<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td class=\"r line-single line-double\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01,530.00<span class=\"u-sr-only\">Double line<\/span><\/td>\r\n<\/tr>\r\n<tr>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>CM ratio<\/td>\r\n<td><\/td>\r\n<td class=\"r\">17.00%<\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n<\/div>\r\n&nbsp;\r\n\r\nContribution margin \/ operating income = 4,930.00 \/ 1,530.00 = 3.2222...\r\n\r\nThis indicates that a 1% increase in sales would increase operating income by 3.22%.\r\n\r\nTheoretically then, an increase in sales of 20% would increase operating income by 20% X 3.22, or 64%. An increase in sales of 20% would be equal to $5,800.00 ($29,000.00 * 0.20), which should then increase the bottom line by $979.20 ($1,530.00 * 0.64).\r\n\r\nThe actual number will be slightly different because we rounded the factor from 3.222\u2026 repeating to just 3.22 and then rounded further when we rounded 0.20 * 3.22 from 64.4% to 64%. This results in an accumulation of errors. If we didn\u2019t round, we would get 0.6444\u2026 repeating, which would result in an increase in the bottom line of $986.00.\r\n\r\nBy increasing unit sales by 20%, we increased the bottom line from $1,530.00 to $2,516, a nominal increase of $986.00.\r\n\r\nIn terms of units, we went from 2900 to 3480, an increase of 580 units, which is 20%.\r\n<div align=\"left\">\r\n<table class=\"fin-table acctstatement fw\"><caption>BlankBooks, Inc.\r\nCVP Analysis - target profit\r\nFor the month ending July 31, 20XX<\/caption>\r\n<tbody>\r\n<tr>\r\n<th class=\"r\" scope=\"col\"><\/th>\r\n<th class=\"r\" scope=\"col\">Units<\/th>\r\n<th class=\"r\" scope=\"col\">$\/Unit<\/th>\r\n<th class=\"r\" scope=\"col\">Total<\/th>\r\n<\/tr>\r\n<\/tbody>\r\n<tbody>\r\n<tr>\r\n<td>Sales<\/td>\r\n<td class=\"r\">3,480<\/td>\r\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a010.00<\/td>\r\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a034,800.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Variable costs<\/td>\r\n<td class=\"r\">3,480<\/td>\r\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a08.30<\/td>\r\n<td class=\"r\">28,884.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Contribution Margin<\/td>\r\n<td><\/td>\r\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01.70<\/td>\r\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>5,916.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Fixed costs<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td class=\"r\">\u00a0\u00a0\u00a0\u00a0\u00a0\u00a03,400.00<\/td>\r\n<\/tr>\r\n<tr>\r\n<td>Operating income<\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td class=\"r line-single line-double\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a02,516.00<span class=\"u-sr-only\">Double line<\/span><\/td>\r\n<\/tr>\r\n<tr>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<tr>\r\n<td>CM ratio<\/td>\r\n<td><\/td>\r\n<td class=\"r\">17.00%<\/td>\r\n<td><\/td>\r\n<\/tr>\r\n<\/tbody>\r\n<\/table>\r\n<\/div>\r\n&nbsp;\r\n\r\nNotice that at this level of sales\/production, our operating leverage number is now 2.35.\r\n\r\nContribution margin \/ operating income = 5,916 \/ 2,516 = 2.35135 (repeating decimal).\r\n<div class=\"textbox shaded\">You could use this as a target (for planning), or a real-time metric (for directing and controlling). For control purposes, it\u2019s a fairly high-level measurement that you would use to identify problems as they arise. You would have to examine detailed data to discover causes and implement solutions.<\/div>\r\n&nbsp;\r\n\r\nNow, let\u2019s check your understanding of the concept of operating leverage.\r\n<div class=\"textbox tryit\">\r\n<h3>Practice Question<\/h3>\r\n[ohm_question hide_question_numbers=1]217767[\/ohm_question]\r\n\r\n<\/div>","rendered":"<div class=\"textbox learning-objectives\">\n<h3>Learning Outcomes<\/h3>\n<ul>\n<li>Calculate operating leverage<\/li>\n<\/ul>\n<\/div>\n<p><strong><img loading=\"lazy\" decoding=\"async\" class=\"size-medium wp-image-1571 alignleft\" src=\"https:\/\/s3-us-west-2.amazonaws.com\/courses-images\/wp-content\/uploads\/sites\/5469\/2021\/01\/12225446\/ashley-byrd-KVby0S0GaH4-unsplash-1-200x300.jpg\" alt=\"Books on display\" width=\"200\" height=\"300\" \/>Operating leverage<\/strong> represents the relationship between the contribution margin and operating income: the difference between those two amounts is fixed costs. The ratio measures the degree to which a company can increase its operating income by increasing sales.<\/p>\n<p>Operating leverage = contribution margin\/operating income<\/p>\n<p>In other words, operating leverage predicts the effect of a change in sales on operating income. The percent increase (decrease) in sales is multiplied by the operating leverage to find the percent increase (decrease) in operating income. The higher the operating leverage, the more impact a change in sales will have on operating income.<\/p>\n<p>Let\u2019s compute the operating leverage for BlankBooks, Inc. at a sales level of 2,900 units:<\/p>\n<div style=\"text-align: left;\">\n<table class=\"fin-table acctstatement fw\">\n<caption>BlankBooks, Inc.<br \/>\nCVP Analysis &#8211; current production<br \/>\nFor the month ending July 31, 20XX<\/caption>\n<tbody>\n<tr>\n<th class=\"r\" scope=\"col\"><\/th>\n<th class=\"r\" scope=\"col\">Units<\/th>\n<th class=\"r\" scope=\"col\">$\/Unit<\/th>\n<th class=\"r\" scope=\"col\">Total<\/th>\n<\/tr>\n<\/tbody>\n<tbody>\n<tr>\n<td>Sales<\/td>\n<td class=\"r\">2,900<\/td>\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a010.00<\/td>\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a029,000.00<\/td>\n<\/tr>\n<tr>\n<td>Variable costs<\/td>\n<td class=\"r\">2,900<\/td>\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a08.30<\/td>\n<td class=\"r\">24,070.00<\/td>\n<\/tr>\n<tr>\n<td>Contribution Margin<\/td>\n<td><\/td>\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01.70<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>4,930.00<\/td>\n<\/tr>\n<tr>\n<td>Fixed costs<\/td>\n<td><\/td>\n<td><\/td>\n<td class=\"r\">\u00a0\u00a0\u00a0\u00a0\u00a0\u00a03,400.00<\/td>\n<\/tr>\n<tr>\n<td>Operating income<\/td>\n<td><\/td>\n<td><\/td>\n<td class=\"r line-single line-double\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01,530.00<span class=\"u-sr-only\">Double line<\/span><\/td>\n<\/tr>\n<tr>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>CM ratio<\/td>\n<td><\/td>\n<td class=\"r\">17.00%<\/td>\n<td><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>&nbsp;<\/p>\n<p>Contribution margin \/ operating income = 4,930.00 \/ 1,530.00 = 3.2222&#8230;<\/p>\n<p>This indicates that a 1% increase in sales would increase operating income by 3.22%.<\/p>\n<p>Theoretically then, an increase in sales of 20% would increase operating income by 20% X 3.22, or 64%. An increase in sales of 20% would be equal to $5,800.00 ($29,000.00 * 0.20), which should then increase the bottom line by $979.20 ($1,530.00 * 0.64).<\/p>\n<p>The actual number will be slightly different because we rounded the factor from 3.222\u2026 repeating to just 3.22 and then rounded further when we rounded 0.20 * 3.22 from 64.4% to 64%. This results in an accumulation of errors. If we didn\u2019t round, we would get 0.6444\u2026 repeating, which would result in an increase in the bottom line of $986.00.<\/p>\n<p>By increasing unit sales by 20%, we increased the bottom line from $1,530.00 to $2,516, a nominal increase of $986.00.<\/p>\n<p>In terms of units, we went from 2900 to 3480, an increase of 580 units, which is 20%.<\/p>\n<div style=\"text-align: left;\">\n<table class=\"fin-table acctstatement fw\">\n<caption>BlankBooks, Inc.<br \/>\nCVP Analysis &#8211; target profit<br \/>\nFor the month ending July 31, 20XX<\/caption>\n<tbody>\n<tr>\n<th class=\"r\" scope=\"col\"><\/th>\n<th class=\"r\" scope=\"col\">Units<\/th>\n<th class=\"r\" scope=\"col\">$\/Unit<\/th>\n<th class=\"r\" scope=\"col\">Total<\/th>\n<\/tr>\n<\/tbody>\n<tbody>\n<tr>\n<td>Sales<\/td>\n<td class=\"r\">3,480<\/td>\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a010.00<\/td>\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a034,800.00<\/td>\n<\/tr>\n<tr>\n<td>Variable costs<\/td>\n<td class=\"r\">3,480<\/td>\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a08.30<\/td>\n<td class=\"r\">28,884.00<\/td>\n<\/tr>\n<tr>\n<td>Contribution Margin<\/td>\n<td><\/td>\n<td class=\"r\">$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a01.70<\/td>\n<td class=\"r line-single\"><span class=\"u-sr-only\">Single Line<\/span>5,916.00<\/td>\n<\/tr>\n<tr>\n<td>Fixed costs<\/td>\n<td><\/td>\n<td><\/td>\n<td class=\"r\">\u00a0\u00a0\u00a0\u00a0\u00a0\u00a03,400.00<\/td>\n<\/tr>\n<tr>\n<td>Operating income<\/td>\n<td><\/td>\n<td><\/td>\n<td class=\"r line-single line-double\"><span class=\"u-sr-only\">Single Line<\/span>$\u00a0\u00a0\u00a0\u00a0\u00a0\u00a02,516.00<span class=\"u-sr-only\">Double line<\/span><\/td>\n<\/tr>\n<tr>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<td><\/td>\n<\/tr>\n<tr>\n<td>CM ratio<\/td>\n<td><\/td>\n<td class=\"r\">17.00%<\/td>\n<td><\/td>\n<\/tr>\n<\/tbody>\n<\/table>\n<\/div>\n<p>&nbsp;<\/p>\n<p>Notice that at this level of sales\/production, our operating leverage number is now 2.35.<\/p>\n<p>Contribution margin \/ operating income = 5,916 \/ 2,516 = 2.35135 (repeating decimal).<\/p>\n<div class=\"textbox shaded\">You could use this as a target (for planning), or a real-time metric (for directing and controlling). For control purposes, it\u2019s a fairly high-level measurement that you would use to identify problems as they arise. You would have to examine detailed data to discover causes and implement solutions.<\/div>\n<p>&nbsp;<\/p>\n<p>Now, let\u2019s check your understanding of the concept of operating leverage.<\/p>\n<div class=\"textbox tryit\">\n<h3>Practice Question<\/h3>\n<p><iframe loading=\"lazy\" id=\"ohm217767\" class=\"resizable\" src=\"https:\/\/ohm.lumenlearning.com\/multiembedq.php?id=217767&theme=oea&iframe_resize_id=ohm217767\" width=\"100%\" height=\"150\"><\/iframe><\/p>\n<\/div>\n\n\t\t\t <section class=\"citations-section\" role=\"contentinfo\">\n\t\t\t <h3>Candela Citations<\/h3>\n\t\t\t\t\t <div>\n\t\t\t\t\t\t <div id=\"citation-list-85\">\n\t\t\t\t\t\t\t <div class=\"licensing\"><div class=\"license-attribution-dropdown-subheading\">CC licensed content, Original<\/div><ul class=\"citation-list\"><li>Operating Leverage. <strong>Authored by<\/strong>: Joseph Cooke. <strong>Provided by<\/strong>: Lumen Learning. <strong>License<\/strong>: <em><a target=\"_blank\" rel=\"license\" href=\"https:\/\/creativecommons.org\/licenses\/by\/4.0\/\">CC BY: Attribution<\/a><\/em><\/li><\/ul><div class=\"license-attribution-dropdown-subheading\">CC licensed content, Shared previously<\/div><ul class=\"citation-list\"><li>Books on display. <strong>Provided by<\/strong>: Unsplash. <strong>Located at<\/strong>: <a target=\"_blank\" href=\"https:\/\/unsplash.com\/photos\/KVby0S0GaH4\">https:\/\/unsplash.com\/photos\/KVby0S0GaH4<\/a>. <strong>License<\/strong>: <em><a target=\"_blank\" rel=\"license\" href=\"https:\/\/creativecommons.org\/about\/cc0\">CC0: No Rights Reserved<\/a><\/em><\/li><\/ul><\/div>\n\t\t\t\t\t\t <\/div>\n\t\t\t\t\t <\/div>\n\t\t\t <\/section>","protected":false},"author":364389,"menu_order":10,"template":"","meta":{"_candela_citation":"[{\"type\":\"original\",\"description\":\"Operating Leverage\",\"author\":\"Joseph Cooke\",\"organization\":\"Lumen Learning\",\"url\":\"\",\"project\":\"\",\"license\":\"cc-by\",\"license_terms\":\"\"},{\"type\":\"cc\",\"description\":\"Books on display\",\"author\":\"\",\"organization\":\"Unsplash\",\"url\":\"https:\/\/unsplash.com\/photos\/KVby0S0GaH4\",\"project\":\"\",\"license\":\"cc0\",\"license_terms\":\"\"}]","CANDELA_OUTCOMES_GUID":"","pb_show_title":"on","pb_short_title":"","pb_subtitle":"","pb_authors":[],"pb_section_license":""},"chapter-type":[],"contributor":[],"license":[],"class_list":["post-85","chapter","type-chapter","status-publish","hentry"],"part":23,"_links":{"self":[{"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/pressbooks\/v2\/chapters\/85","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/pressbooks\/v2\/chapters"}],"about":[{"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/wp\/v2\/types\/chapter"}],"author":[{"embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/wp\/v2\/users\/364389"}],"version-history":[{"count":11,"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/pressbooks\/v2\/chapters\/85\/revisions"}],"predecessor-version":[{"id":1573,"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/pressbooks\/v2\/chapters\/85\/revisions\/1573"}],"part":[{"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/pressbooks\/v2\/parts\/23"}],"metadata":[{"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/pressbooks\/v2\/chapters\/85\/metadata\/"}],"wp:attachment":[{"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/wp\/v2\/media?parent=85"}],"wp:term":[{"taxonomy":"chapter-type","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/pressbooks\/v2\/chapter-type?post=85"},{"taxonomy":"contributor","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/wp\/v2\/contributor?post=85"},{"taxonomy":"license","embeddable":true,"href":"https:\/\/courses.lumenlearning.com\/suny-clinton-managerialaccounting\/wp-json\/wp\/v2\/license?post=85"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}