Operating Leverage
Operating Leverage
The degree of operating leverage (DOL) is the ratio of the percentage change in EBIT to the percentage change in sales. It can be defined by the following equation, which gives three equivalent forms of the right side:
∆ EBIT
% ∆ EBIT
∆ EBI T T Sales
DOL =
EBIT
% ∆ Sales ∆ Sales
EBIT ∆ Sales
Sales
A more direct way for calculating the degree of operating leverage is
Sales Variable Cost −
A firm’s operating leverage is sensitive to the relative amounts of its fixed and variable costs. If a firm’s costs are all variable (i.e., if there are no fixed costs), and if the variable costs are a constant percentage of the sales, the percentage change in EBIT will exactly equal the percentage change in sales. However, if a firm has fixed costs as well as variable, the percentage change in EBIT will be greater than the percentage change in sales.
The degree of operating leverage for the ABC Company can be computed by substituting values from Figure 10-5 in equation 10.9. Thus,
The following example considers the choice between two processes—a labor-intensive one and a capital intensive one—that a company is considering for manufacturing a product.
Profit, Break-Even, and Leverage ❧ 335
Example 10.1: The Hancock Corporation is considering two processes to manufacture a product. Process A is a labor-intensive process with relatively low fixed cost and high variable cost. Process B is a capital-intensive process with relatively high fixed cost and low variable cost. Values are as follows:
Process A (Labor-Intensive) Process B (Capital-Intensive)
Fixed cost = $10,000/year
Fixed cost = $20,000/year
Variable cost = $7/unit
Variable cost = $5/unit
Hancock expects to sell 5,000 units a year at a selling price of $10/unit. (Since the product is the same for both processes, the selling price of the product is the also the same for both processes.)
a. What is the firm’s operating leverage for each process at the expected number of units sold? b. What is the firm’s operating leverage for each process if the number of units sold is 10 percent greater than expected?
c. What is the firm’s operating leverage for each process if the number of units sold is 10 percent less than expected? d. What are the percentage changes in DOL and EBIT for a 10 percent increase and a 10 percent decrease in the number of units sold? e. Interpret the results in terms of their impact on a firm’s strategy.
Solution: Figure 10-13 is a spreadsheet solution. The operating leverage at the base condition is calculated by two different methods.
a. Method 1: The operating leverages at the base conditions can be evaluated by comparing the results when the sales volume is changed with the results at the base conditions. The results in Rows 4 to 24 show the comparison at the base conditions and for a 10 percent increase and a 10 percent decrease in the number of units sold. Key cell entries are shown at the bottom of the spreadsheet.
The operating leverages at the base conditions are 3.00 for Process A (Cells C18 and D18) and 5.00 for Process B (Cells F18 and G18). Method 2: Substituting in equation 10.9 gives the same results; thus,
(, 5 000 units )($ / 10 unit )(, − 5 000 units )($ 7 // unit ) $, 15 000
(, 5 000 units )($ / 10 unit )(, − 5 000 units )($ 5 // unit ) $, 25 000
b. For a 10 percent increase in the number of units sold, Process B enjoys a greater increase in EBIT ($2500, Cell F14) than Process A ($1500, Cell C14). At the new sales level, the operating leverages are lowered to 2.54 for Process A and 3.67 for Process B.
c. For a 10 percent decrease in the number of units sold, Process B suffers a greater decrease in EBIT (-$2500, Cell G14) than Process A (-$1500, Cell D14). At the new sales level, the operating leverages are raised to 3.86 for Process A and 9.00 for Process B.
d. The percentage changes in DOL and EBIT from the base conditions are shown in Rows 23 and 24 of Figure 10-13. Note that the swings in these values are much higher for Process B than for Process A.
(Continued)
336 ❧ Corporate Financial Analysis with Microsoft Excel ®
e. We might reasonably conclude from this analysis that if there is a high probability that demand for the product will be low and Hancock is in such financial shape that it would be difficult to cope with a large reduction in its expected EBIT, the CFO should prefer Process A. On the other hand, if the company is in good financial shape and it is likely that demand for the product will be strong, the CFO should choose Process B.
Figure 10-13
Operating Leverage at Base Conditions and for 10% Increases and Reductions in Sales Volume
1 HANCOCK CORPORATION
2 Process A
Process B
Increase in
Decrease in
Increase in Decrease in
Sales Sales 4 Fixed cost
3 Base Sales
Sales
Sales
Base Sales
20,000 $ 20,000 5 Unit variable cost
$5.00 $5.00 6 Selling price
$10.00 $10.00 7 Units sold per year
5,500 4,500 8 Break-even point, units
4,000 4,000 9 Sales revenue
55,000 $ 45,000 10 Less variable costs
27,500 $ 22,500 11 Less fixed costs
Changes from Base
14 Change in EBIT
2,500 $ (2,500) 15 Relative change in EBIT
50.0% –50.0% 16 Change in sales revenue
5,000 $ (5,000) 17 Relative change in sales revenue
10.0% –10.0% 18 Operating leverage at base
Operating Leverage at Conditions in Row 3 20 Sales less variable costs, SLVC
27,500 $ 22,500 21 Degree of operating leverage, DOL
Percent Changes from Base Conditions 23 Percent change in DOL
–26.7% 80.0% 24 Percent change in EBIT
Key Cell Entries
B8: =B4/(B6–B5), copy to C8:G8 B20: =B9–B10, copy to C20:G20 B9: =B7*B6, copy to C9:G9
B21: =B20/B12, copy to C21:G21 B10: =B7*B5, copy to C10:G10
F14: =F12–$E12, copy to G14 B12: =B9–B10–B11, copy to C12:G12
F15: =F14/$E12, copy to G15 C14: =C12–$B12, copy to D14
F16: =F9–$E9, copy to G16 C15: =C14/$B12, copy to D15
F17: =F16/$E9, copy to G17 C16: =C9–$B9, copy to D16
C23: =(C21–$B$21)/$B$21, copy to D23 C17: =C16/$B9, copy to D17
F23: =(F21–$E$21)/$E$21, copy to G23 C18: =C15/C17, copy to D18 and to F18:G18
C24: =C14/$B$12, copy to D24 F24: =F14/$E$12, copy to G24
Profit, Break-Even, and Leverage ❧ 337