hello and welcome to this session in which we would look at the degree of operating leverage or dol now what is a leverage or what is a lever simply put a lever is a tool for multiplying for giving you more power simply put a modest amount of power can move massive object think of a wheelbarrow well a wheelbarrow can help you because it's it's it's you you can lever it to move a massive object you cannot move yourself and this is what a lever is but we're talking here about the degree of operating leverage when the company operate how sensitive is net income or net operating income to a giving percentage change in sales in sales so simply put when you're when your top line sales changes how is that going to affect your profit your bottom line what is the chain what's the effect how sensitive is your bottom line to that effect a higher operating leverage means a small change will would lead to a higher effect on profit if you have a high degree of operating leverage now the best way to illustrate this is to actually look at an example to show you what it means from a numbers perspective we're going to be working with the same company that i work with earlier when we talked about cost structure and that's lean company and big company remember remember both of these companies are in the business of picking olives big company they use automation they have a higher fixed cost lean company they rely on labor and they have a lower fixed cost and basically at this point both companies have sales of 100 000 and their net operating income is 10 000 given that company b has a higher higher fixed cost company a company b which is big and the lean company has a higher variable cost now let's compute the degree of operating leverage for each company and see how would that affect their bottom line well we compute the degree of operating leverage by taking contribution margin which is sales minus variable expenses dividing it by net operating income and if we do so for lean company we find out that the degree of operating leverage equal to four if we do the same computation for big company we find out the degree of operating leverage is seven obviously big has a higher degree of operating leverage it means the net operating income increase four percent increases for four times as fast as sale for lean as fast as sales for lean company and it increases seven times as fast as sales for a big company so if sales increase by 10 percent which something that we looked at when we did the cost structure what would happen to the bottom line for each company notice big company profit will become 17 000 so simply put we increased sales by 10 percent and notice increasing sales by 10 percent increased our profit by 70 percent that's a huge increase in profit at the same time if you look at the lean company they also increase sales by 10 they went from one one one hundred to one ten however their profit only went up forty percent forty percent still good but seventy percent is way better so the higher the degree of operating leverage the more sensitive the changes in sales to your net income to your profit now bear in mind also on the downturn that's also true so you have to be very careful now the degree of operating leverage is not constant what does that mean it means you don't get the same degree of operating leverage as the company grows let's take a look at this example in here we are looking at a company with a 40 contribut contribution margin percentage they have sales of 75 variable expenses of 45 will give us a contribution margin of 30 000 the fixed cost is 30 30 divided by 75 equal to 40 percent 30 minus 30 equal to zero we cannot compute the degree of operating leverage let's assume sales went up by 5 000. well variable expense will go up proportionally now the contribution margin is 32. the net operating profit is 2000. now if we compute 32 divided by 2 the degree of operating leverage is 16. let's increase sales from 80 to 100 000 again increase variable expenses proportionally contribution margin percentage is 40 percent fixed cost is the same 30 000 now and the profit is 10 if we take contribution margin divided by net operating income will give us a dol of 4. if we increase sales from 100 to 150 the degree of operating leverage is 2 if we increase sales from 152 to 25 the degree of operating leverage is 1.25 so notice as we are as we are going away from the break even point we have lower and lower degree of operating leverage and that's the importance of the break even and that's why a lot of a lot of a lot of managers they want to get to the break even because once they go a little bit about the break even that small increase in the break-even will yield a larger net operating income if you have any questions what you should do now go to foreheadlectures.com and work mcqs if you're not a subscriber go ahead and subscribe i can help you with your accounting courses cpa preparation invest in yourself don't 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