LINK BETWEEN OPERATING LAVARAGE AND BEP Prepared by Iryna Progoniuk
BREAK EVEN POINT CONCEPT • Break even point (BEP) - is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has “broken even”. • BEP formula: Fixed cost BIP = Contribution margin ratio Fixed costs – expenses which do not change as a function of a business activity, within a required period of time (e.g. rent, insurance, salaries, capital assets etc.) Variable costs - expenses which keep changing in proportion to the activities of a business (e.g. fuel, raw materials, packaging, wages, food items etc.)
OPERATING LEVERAGE CONCEPT • Operating leverage (OL) – is the ratio of a company's fixed costs to its variable costs. The larger the proportion of fixed costs to variable costs, the greater the operating leverage. • The main goal of OL: to measure how changes in sales can affect net income. • OL formula: Quantity x (Price – Variable Cost per Unit OL = Quantity x (Variable Cost per Unit) – Fixed Operating Cost
LINK BETWEEN OL & BEP • High operating leverage means high fixed costs while low operating leverage means low fixed costs. • The higher are the fixed costs – the higher BEP level expected. Higher levels of operating leverage tend to result in wider variations in profits given a change in sales. This variation is called operating risks. Therefore, higher levels of fixed costs are often associated with high levels of operating risks which in turn leads to fluctuations of earnings given a change in sales. • The lower are the fixed costs – the lower BEP level needed. • BIP analysis is often used in conjunction with OL. As we increase sales beyond the breakeven point, the effects of operating leverage diminish since the sales base we are using has increased. We can use BIP analysis to calculate operating leverage.
PRACTICAL EXAMPLE ZZZ Company YYY Company (1) Fixed costs $60,000 $15,000 (2) Contribution margin ratio 0.75 0.30 (1) ÷ (2) Break-even point $80,000 $50,000
• Conclusion: as we can see from the table above, ZZZ Company needs to generate $80,000 in sales to break even while YYY Company only needs $50,000. ZZZ Company needs $30,000 more in sales than YYY Company before it breaks even: this makes ZZZ Company riskier than YYY Company