BUSMGT713 Chap.3 Operating leverage and cost structure risk
Operating leverage and cost structure risk
The second Week 1 activity compares two companies that pay for the same work in different ways: one with low fixed and high variable costs, the other with high fixed and low variable costs. This chapter follows that comparison with two print shops, one outsourcing its printing and one owning a press whose faster turnaround earns a slightly higher price.
It draws their profit-volume lines from two points each, the loss at zero volume and the break-even volume, and solves for the volume at which their profits are equal. It then measures risk the way the practice mid-term does: operating leverage as fixed costs divided by total costs, alongside the margin of safety ratio.
A worked decision asks whether the outsourcing firm should buy a press at its forecast demand, and a comparison at the forecast and 30% either side of it shows why the firm with more fixed cost gains more when sales rise and suffers more when they fall. Its worked decision shows a case in which the riskier structure is still the right choice for the forecast.
What this chapter covers
- 01
Low fixed and high variable cost against high fixed and low variable cost
- 02
Drawing a profit-volume graph from two points
- 03
The volume at which two cost structures earn equal profit
- 04
Operating leverage as fixed costs over total costs
- 05
Margin of safety as a second risk measure
- 06
Choosing a structure from a demand forecast
Worked example · free
Printhub and Pressline: the equal-profit volume on the profit-volume graph
- +1Contribution per job: Printhub $20 minus $15 = $5; Pressline $21 minus $8 = $13.
- +2Break-even: Printhub $12,000 divided by $5 = 2,400 jobs; Pressline $52,000 divided by $13 = 4,000 jobs.
- +2Equal profit: 5 times jobs minus $12,000 = 13 times jobs minus $52,000, so 8 times jobs = $40,000 and jobs = 5,000.
- +1Profit at 5,000 jobs: $5 times 5,000 minus $12,000 = $13,000, and $13 times 5,000 minus $52,000 = $13,000.
Key terms
- Cost structure
- The mix of fixed and variable costs a business carries, shaped by choices such as owning equipment or outsourcing work.
- Operating gearing
- Another name for operating leverage, describing how strongly profit responds to a change in sales volume because of fixed costs.
- Equal-profit volume
- The level of activity at which two alternative cost structures produce exactly the same profit.
- Profit-volume graph
- A chart of profit against activity, starting at a loss equal to fixed cost and crossing zero at break-even.
- Operating risk
- Exposure of profit to falls in sales volume, greater when fixed costs form a larger share of total costs.
Operating leverage and cost structure risk FAQ
How is operating leverage calculated in this course?
The practice mid-term solution divides fixed costs by total costs for each product, reporting the result to two decimal places, and treats the product with the higher figure as carrying the higher operating risk. It pairs that measure with the margin of safety ratio, so give both when a question asks which option is riskier.
How do I find the volume where two cost structures earn the same profit?
Write each profit as contribution per unit times units minus fixed costs, set the two expressions equal and solve. The answer equals the difference in fixed costs divided by the difference in contribution per unit. Below that volume the lower fixed-cost option earns more; above it the higher-contribution option wins.
Why is a high fixed-cost business riskier?
Its fixed costs must be covered whatever happens to sales, and each lost unit removes a larger contribution. When volume falls, profit drops more than proportionately and can turn into a loss quickly. The same mechanism works upward, which is why the workshop notes link high gearing to higher potential returns.
Is the lower-risk cost structure always the better choice?
No. Which structure earns more depends on expected volume. If demand is steady and well above the equal-profit volume, the higher fixed-cost option produces more profit and its extra risk may be worth carrying. A recommendation should quote the forecast, the equal-profit volume and both risk measures.
How do I draw a profit-volume graph quickly?
Plot two points for each option: a loss equal to fixed cost at zero activity, and zero profit at the break-even volume. Join them with a straight line whose slope is contribution per unit. Where two lines cross is the equal-profit volume, which the workshop solution finds algebraically.
Assessment move
Lay out every cost-structure comparison in a two-column table: price, variable cost, contribution per unit and fixed cost for each option. Compute both break-evens, then the equal-profit volume, and sketch the profit-volume lines to see the crossing. Next compute operating leverage as fixed costs over total costs at the volume the question gives, to two decimal places, and the margin of safety ratio for each.
Test both options at a lower and a higher volume to see how profit swings. Finish with a recommendation that names the forecast volume, compares it with the equal-profit volume and states which option carries more operating risk and why. Repeat with a new pair of options until the full routine takes ten minutes.
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