Information Needed to Answer The Case Study

Determining variable and fixed costs leads us to ask the question. Why bother studying these costs?

To determine operating leverage

To determine the companys ability to adapt to changing sales levels

To find the break-even sales point.

Degree of Operating Leverage

The term operating leverage refers to fixed costs. Consider:

High Fixed Costs = High Degree of Operating Leverage (HDOL)

Low Fixed Costs = Low Degree of Operating Leverage (LDOL)

Companies with high fixed costs versus variable costs have higher operating leverage. Why?

Companies with a HDOL must reach a higher level of sales to cover fixed costs before profits can occur. Once sales exceed that level, profitability increases dramatically since variable expenses are much smaller than fixed costs (which have already been covered).

On the other hand, companies with LDOL, will have lower fixed costs, but every dollar of sales will be chewed up by variable costs leaving a modest profit.

Conclusion: Higher Leverage companies must have high level of sales compared with capacity, in order to cover all expenses (to reach breakeven).

Why do lenders care about Operating Leverage?

If companies with high operating leverage see a decline in sales, profits will be adversely impacted since it will be more difficult to cut expenses. Since debt service is in essence a fixed cost, this could lead to a default on debt service.

Formulas

Degree of Leverage (DOL) quantifies the magnifier effect of a high level of fixed costs, that is an increase of X% in sales will result in an increase of profit before taxes of X% times the DOL.

Operating Leverage = Sales Total Variable Cost

Sales Total Cost (Fixed and Variable)

In order to find the breakeven sales for a company, divide the companys fixed expenses (usually operating expenses and other expenses) by its profit after variable expenses as a percentage of sales (usually gross profit as percentage of sales). The answer is the break-even sales point.

Breakeven Sales Point = Total Fixed Expenses

(1 minus Variable Expenses as a % of sales)

Understanding the above formulas can be difficult without an example. This can be difficult to understand without an example.

Conclusion

Companies with a higher fixed overhead (and hence, lower variable costs relative to fixed costs) must reach a higher level of sales prior to becoming profitable. However, they will enjoy a greater increase in profits as sales increase.

	High Operating Leverage	Low Operating Leverage
Breakeven	Higher	Lower
Increase In Profits	Faster	Slower

You own and manage a pretzel and lemonade concession cart. You decide that you want to sell your products at a NASCAR race weekend in Loudon, NH. The racetrack owners let you choose one of the following rental options: Low Overhead Rent - Commission of 30% of total sales High Overhead Rent - $1,000 fixed rental cost for the entire weekend Your food and beverage costs are 20% of total sales. You also have to pay an employee $400 to run the cart over the weekend. Question 1 Find Breakeven For each scenario, calculate at what level of sales where you will reach the breakeven point. Question 2 Calculate Degree of Operating Leverage You estimate that your sales for the weekend will either be average or great: Average: $2,800 in sales Great: 50% higher than average or $4,200 What is your degree of leverage at AVERAGE sales of $2,800 for both the low and high overhead scenario? Operating Leverage = Sales Total Variable Cost Sales Total Cost (Fixed and Variable) Question 3 Calculate Profits and Increase In Profitability Calculate the profit potential for an average and great weekend for both the low overhead scenario and the high overhead scenario. How much did profits increase by relative to an increase in sales for both scenarios? How does this compare with the answers you derived in question 2?