 Hello and welcome to the session. This is professor for had in which you would look at the degree of operating leverage We're gonna compute that degree of operating leverage And we're gonna explain the effect of the degree of operating leverage of two at two different companies a tack and Z-tack before I start I would like to remind you to connect with me on LinkedIn if you haven't done so Please subscribe to my YouTube what I have close now to two thousand plus YouTube lectures about financial accounting Auditing tax finance and various accounting courses, and if you're studying for your CPA exam I practically have many if not all accounting audit and tax topic covered on my website You will find additional resources and in addition to my lectures that will help you in your CPA or your accounting And some of your finance courses. I strongly suggest you check out my website So let's take a look at this exercise and see how we compute the degree of operating leverage We have two companies. We have a tack has a fixed cost of seven million and profit of four million its competitor Z-tack is roughly the same size and this year earned the profit of four million notice the profit is the same But it operates with a higher fixed cost of eight million in a lower variable cost Obviously if it made the same income and it has a higher fixed cost It must have a lower variable cost. So the first thing we're gonna compute is Each firm operating leverage and we're gonna see which one the higher operating leverage and which firm will likely have a higher Profit of the economy strengthen. So I'm gonna do both if the economy strengthen or if the economy weakened So let's take a look at what we are giving Simply put I'm gonna make up some numbers for a tack and Z-tack. So I'm gonna assume sales is 13 13 million. This is all in million Notice fixed cost is all what they're given us in this problem is fixed cost and profit for a tack fixed cost and profit for For for Z-tack. So I'm gonna make up some numbers. This is actually what I did So I took so I assumed sales is the same for both variable cost is to For a tack minus seven so 13 million minus two variable cost minus seven fixed cost equal to the profit of four million Z-tack same sales minus variable cost of one minus fixed cost of eight equal to four So notice I make them both the same has the same profit with different with different variable and fixed cost Now the first thing is which has a higher operating leverage Hopefully without even performing the computation. You would know that Z-tack Has a higher operating leverage Why because looking at their profit relative to their fixed cost this one has a higher fixed cost But simply put if you want to compute the degree of operating leverage the formula as you'll take your fixed cost divided by profit and You add one you add one to this computation. So if we take Fixed cost which is eight fixed cost is eight and I'm sorry. Let's start with a tack Seven divided by four Plus one. It's gonna give us two point seven five the degree of operating leverage for a tax So this is two point seven five. Let's do the same thing for Z-tack Eight divided by four plus one. That's equal to three So the degree of operating leverage is three as I told you without even doing the computation You would know that Z-tack is is more leverage than a tech now. What does that mean? Two point seven five and three so it's very important that you understand What does it mean the degree of operating leverage because it's easy to compute? I mean I could have answered this question without even doing any computation as long as you have a basic understanding of it Well, let's assume so let's assume. We're gonna ink the economy strengthened and sales It's gonna increase 20 percent for a tack and 20 percent for Z-tack. So let's look at the effect of That 20 percent increase in sales for both companies. So if we increase 13 million by 20 percent, it's gonna give us 15.6 million We're gonna increase the variable cost exactly by 20 percent. It's gonna be 2.4 million So basically what I did is I took 13 times 1.2 2 times 1.2 Which is 20 percent the original figure and add 20 percent to it fixed cost is the same That's the nature of fixed cost. Therefore the profit will be 6.2. So notice sales sales went up by sales so sales went up by 20 percent The profit margin went from four to six six point two profit margin went up by 55 percent Let's look at Z company same thing Sales went up by 15 variable cost. I'm sorry went up to 15 point six by 20 percent variable cost up by 1.2 Fixed cost stayed the same. Their profit is 6.4 notice the the increase so sales increase by 20 percent The profit increase by 60 percent. Well the profit increase really three times and this is the degree of operating leverage simply put What you do once you compute that 2.7 and 3 Once you compute the 2.7 and 3 the degree of operating leverage all what you have to do to find out What's the effect on the bottom line and any changes in sales? So if sales went up 20 percent you will take 20 percent times 2.75 will give you 55 percent And this is how we computed 55 percent Z company if sales increase by 20 percent the same as a a tech Times 300 percent sales will increase by 60 percent. So notice because Z company is more leverage What's gonna happen the more sales they make? The higher is the bottom line the higher is the bottom line relative to a tech because a tech actually both companies are Leveraged in this situation. I mean very leverage I'm gonna work another example where one one company is more leverage than the other now Let's look at the downturn what happened in a downturn now. Let's assume sales goes down by 20 percent Let's see how the this red that's that this reduction in sales will affect the bottom line So we'll take sales 13 times point eight, which is 10.4 Two times point eight because this is very variable cost goes down by the same amount fixed cost is the same The profit is 1.8 notice We brought we brought sales down now sales went down the sales went down 20 percent The reduction in the profit is 55 percent and you can guess sale went down by 20 percent for Z company the profit went down by 60 percent. So notice Z company is more affected negatively It's more affected positively when when the sales goes up, but it's more affected negatively But again, this is not the best example because notice they're both kind of highly leverage Relative to variable cost. Let's change to show you the effect even higher Let's assume a tack has a sales of 13 Variable cost of six and fixed cost of three so what I'm doing is I'm changing a tack make it more variable cost company The profit equal to four Z tack. I'm gonna keep it the same They have one dollar and variable cost eight dollar and fixed cost So we're starting at four and four now if we compute their degree of operating leverage a has 1.8 and Z tack it's gonna be the same three now Let's change sales by 20 percent now. Well, if we change sales by 20 percent, what's gonna happen? If we change sales by 20 by 20 percent only have to take 20 percent times 1.8 dirt profit will increase by 35 percent. So the difference between this profit the increase in profit is 35 percent however The the change for Z company the change in profit is 60 percent huge difference Notice it's only so notice they both increase by 20 percent This is only went up 35 this 20 percent for Z company went up 60 percent Almost not double but close to a double the effect on Z company in terms of profit But also let's go ahead and in that time sales went down by 20 percent now The profit goes down to 2.6. It goes down 35 percent here The profit goes to 1.6 goes down by 60 percent so on the downturn Z company is more affected And that's the power of leverage in good time leverage Leverage will will will translate and more an an additional profit in pure profit more to your bottom line But in that time you will be if you will be affected more negatively and remember this is operating leverage We also have financial leverage very similar concept financial leverage is when you have that because that is a fixed cost so that will be a fixed cost so you could also Compute that leverage based on that and we'll talk about this later on when we talk about the financial statement analysis later on In this course as always if you like this recording Please like it and share it and I'm gonna always invite you to visit my website farhat lectures calm for additional resources For this course or especially for your CPA exam study hard Stay safe and good luck