Question

I am a bit confused with the concept of "Operating Leverage". I understand its formula of the ratio of Contribution margin to Net income but I cannot clarify how its increase can have a negative impact on the profits and increase in risk.

Answer 1

Impact on Profit:

Contribution margin - Fixed cost = Net income

Operating leverage = Contribution margin / Net income

Let we assume, Contribution margin = 200,000 $, Fixed cost = 100,000 $

Now Net income = 200,000 - 100,000 = 100,000 $

Operating leverage = Contribution margin / Net income = 200,000 / 100,000 $ = 2 times

Let we assume now, fixed cost is increased to 150,000 $

Net income = Contribution - Fixed cost = 200,000 - 150,000 = 50,000 $ net income

Operating leverage = Contribution margin / Net income = 200,000 / 50,000 = 4 times

So, Increase in fixed cost from 100,000 to 150,000 resulted an increase in operating leverage.

By this calculations, If operating leverage increases, net profit will decrease.

In first case, net profit = 100,000 $ and in second case, net profit = 50,000 $

So, there is a negative impact on profit if operating leverage increases.

Risk:

In first case, the company has to generate a contribution margin of 100,000 $ to break even i.e no profit no loss situation.

In second case, the company has to generate a contribution margin of 150,000 $ to have no profit no loss situation.

Company has to make additional efforts than in first case. This is known as risk.

So, second case have more risk or need to sell more products than the first case.

So, If operating leverage increases, the risk also increases.