 Hello and welcome to this session in which we would look at operating leverage. What is operating leverage? It's a measure of how revenue growth translates into operating income. So simply put, if we look at the income statement, we have revenue at the top minus all expenses, cost of goods sold, so on and so forth. And at the bottom, we are going to have a profit or you can call it operating income, whatever you want to call it. Okay. Now, the question is, how does the change in revenue affect the change of the bottom line in operating income? And this is what the operating leverage is measuring. And simply put, what's going to make the difference is the cost structure. And basically our cost could be fixed cost, could be variable cost, and the fixed cost could take many forms such as interest, for example, interest expense is a fixed cost. Now, this topic is important whether you are taking an accounting course or the CPA exam. Especially if you are studying for your CPA exam, I strongly suggest you take a look at my website, farhatlectures.com. I don't replace your CPA review course, you can keep them, I don't replace them. My intent is to be a useful addition to explain the material differently. And by doing so, add 10 to 15 points to your score. How so? If I help you understand your review course better, your review course will help you do better on the CPA exam. I fill those gaps that you have not learned in college or if you learned it, you did forgot it. What happened is this, here's my offer simply, one month of subscription, that's your risk with me. Your potential gain is passing the exam, your maximum risk is one month of subscription. If you like my system, you keep it. I have helped hundreds, if not thousands of candidates pass the exam. If you feel, you know, that wasn't as good as I wanted, then you can cancel. But if not for anything, take a look at my website to find out how well or not well your university doing on the CPA exam and take a look at my accounting and other finance and CPA sections. Please connect with me on LinkedIn if you haven't done so. Take a look at my LinkedIn recommendation, like this recording, share it with other, connect with me on Instagram, Facebook, Twitter and Reddit. In order to understand the operating leverage on probability, you need to understand how fixed cost and variable cost as well as mixed cost behave. If you don't know how to, what mixed cost, variable cost or fixed cost behave, please go back and view chapter two part one, which is I explained how fixed cost, variable cost and mixed cost behave. So what is operating leverage? It's a measure of the extent to which fixed cost are being used in an organization. So basically what you are using, you are using fixed cost as a leverage. What is a leverage? Basically leverage is using something else to help you produce a lot of profit. So you have a lot of leverage or not a lot of leverage. When you have a lot of fixed cost, you might have a lot of leverage, but leverage we're going to see is a double edge sword. So we're going to see what do I mean by this. So operating leverage is the greatest in companies that have a high proportion of fixed cost. So basically when you have high fixed cost, you have more operating leverage. So you can make more profit. We're going to see in good years, but in another not good years, you're going to be making less profit. So when you have more leverage, you're going to have more profit. So to illustrate this point, let's go ahead and use an example. So let's take a look at this example. Now we're going to start by saying ticket sold for a company is 2700. The revenues is a ticket sold times $18. The revenues is 48600 and we assume that the cost of the band is 48000. So what's left for gross profit only $600, but notice the cost is totally fixed. Here's what's going to happen. We're going to go from 2700 tickets sold and we're going to increase the tickets only to 3000. So we're going to increase the tickets by 300 tickets. That's it. And if you're interested in knowing what is a 300 over 2700 is, so if we take 300 divided by 2700, so it's an 11.11 percent increase. So let's say 11%. So what we did is we increased sales by only 11%. So sales increased by 11%. So let's see what's going to happen because sales increased by 11%. Well, if sales increased by 11% we sold 3000 tickets times $18 per ticket. The total revenue is 54000. Now our cost for the band is a fixed cost of 48000. So 54000 minus 48000 gross profit is $6000. That's a huge increase in gross profit. We went from 11%. This is a 10 times when the profit, 10 times. Let's keep on going. If we increase the number of tickets sold by 10% from 3000 to 3300, 3300 tickets times $18 per ticket, the revenue is 59400. The fixed cost is the same, 48000. Now we are at 11400. So by increasing sales, the number of tickets by only 10%, we increase gross profit by 90%. We increase gross profit by 90. So why does this happen? Well, this happens because our cost is fixed. We are using leverage. In other words, once we meet the fixed cost, once we reach that hurdle, every extra dollar we sell above the fixed cost is strictly profit. So strictly profit. So if you want to really think about it in another way, here we sold, once we break even, we haven't used the term break even first, but let's assume when we moved from 2700 to 3000 tickets, we sold 300 additional tickets. All the 300 additional tickets times $18, the whole thing was profit, was pure profit. And what is 3000 times 18? Let's just get the calculator. If we look at 300 times 18, it's 5400. The increase is 5400. And notice, the 5400, so the increase in sales was 5400, and the whole thing, the 5400 went into the profit. So the whole amount that we increased in sales went into the profit. Again, we increased the number of sales by 300 tickets again, from 3000 to 3300 times 18, the whole 5400 went to the profit immediately. And this is the power of leverage, because you're using your fixed cost as a leverage. You're using the fixed cost as a leverage, as an operating leverage. So every extra dollar that you sell, it goes directly into the profit. So that's the idea of leverage. When all costs are fixed, every additional sales contribute to $1 in gross profit. Risk and reward assessment. So what is risk? Risk refers to the profitability that sacrifices may exceed benefit. So this is how risk is. And risk may be reduced by converting fixed costs into variable costs. So if you have a fixed cost, yes, you have leverage, but you also have risk. The more fixed costs you have, the higher is your risk. And we're going to show you why. So we have to understand this concept. And the more variable costs you have, you have less risk as a company. So let's see what would happen if the band received $16 per ticket sold instead of a fixed cost of $48,000. Let's assume if the band would receive $16 per ticket rather than the $48,000 upfront. Let's see what happened to their ticket sold. Let's see what happened to their revenue. If they sold 2,700 tickets, the revenue per ticket is $18. And the cost of the band, we're going to pay the band $16 times $2,700. So the gross profit is $5,400. Now we're going to go from $2,700 to $3,000 tickets. To go to $3,000 tickets, once again, $3,000 times $18 is $5,400. Then we have to, the band cost goes up. The cost of the band goes up. Remember, because this is a variable cost, $16 times $3,000, which is $48,000. And our profit is $6,000. If we increase the sale ticket by 10%, again, our revenue is $3,300 times $18,000, $59,000, $3,300 times $16,000. Our cost also increases. And our revenue increases. But remember, when it was fixed costs, every time we increase revenues by 10%, the gross profit increased much, much more. So what can we say? Well, a 10% increase in revenues only gave you a 10% increase in gross profit. So shift in the cost structure from fixed to variable, not only reduces risk, but also reduces the potential profit. Because you only make more profit if you are taking more risks. With variable cost, what's happening is, if your cost is variable, you're taking less risk because you don't care if one person show up, a lot of people show up, because your cost is variable. I mean, you want more people to show up, but your cost is variable. You don't have that urgency to meet the $48,000. When you had to come up to pay for the concert, $48,000 as a fixed cost, you were eager to meet that cost. Because if you don't meet that cost, you're going to lose money. But in this situation, if you sold one ticket, and one person show up, and if you sold one ticket, $18,000 minus $16,000, you make $2 per profit. If you sold two tickets, you're going to make $4,000. Three tickets, $6,000, so on and so forth. So your revenue would increase by $18,000, and your expenses will increase by $18,000. So this is times two, and this is times two. So your revenue increases, and your cost also increases. But with a fixed cost, if you sold only one ticket, if you sold only one ticket, you're going to be way, way at a loss here. So shifting your cost to a variable cost, it's going to help you reduce the risk, but also your profit will go down as well. Your profit will slow down. Let's take a look at these three examples side by side. Let's assume the first company has all fixed costs. So all fixed costs means this is a risky company. They sold 10 units. The selling price per unit is $10. They don't have no variable cost because it's a 100% fixed cost company. Sales revenue is $100. Total variable cost is 0. Total fixed cost is $60, and this is a fixed cost. So the profit is $40. Same company would have a combination company, 10 units sold, $10 per ticket. The variable cost is $30. So this company has both a variable cost and a fixed cost. So the sales revenue is 10 times 10 equal to 100. The variable cost is 10 times 30. And the total fixed cost is $30. So this is a mixed cost scenario. Also the net income is $40. This is all variable cost. We sold 10 units, each unit at $10. The variable cost per unit is $6. Total revenue is $100. Variable cost is $60. No fixed cost. No fixed cost. And this is the cost is $40. So now we're going to see what happened when the number of units sold increases. So what should happen if we sell more units? Based on what we know, what should happen? Well, think about it for a moment. What should happen if we sell more units under each of these scenarios? Who do you think it's going to benefit the most? Well, I hope you know the answer. And all fixed cost companies should benefit the most. Let me show you how mathematically. If we sold 11 units rather than 10, the selling price per unit is 10. So we're going to receive $110. No variable cost. Now we are lucky. We are using the leverage. The leverage here is the fixed cost. We no longer have to pay extra cost because our cost is fixed. So our net income is $50. Same scenario for a company that has a combination of variable and fixed. If they sold 11 tickets, $10 per ticket, revenue is $110. Then the variable cost is 11 times 3, which is $33. The fixed cost is $30 because this is $50. And the profit is $47. Notice the profit is lower than if it's 100% fixed. If the company is 100% variable, all their cost is variable. If they sold 11 tickets, $10 per ticket, their revenue is $110. Their variable cost is 11 times 6, which is $66. They have no fixed cost and their profit is $44. So notice the company does best if their cost is fixed and they increase the number of units sold because for a fixed cost company, the goal is to go over the hurdle. And the hurdle in this example is $60. Now let's assume on the other hand, they sell one less ticket. Instead of 10, they sold nine tickets. So we're going to decrease in comparison to the original example. Well, what's going to happen to all fixed cost companies? They're going to sell nine units at $10. The total revenue is $90. They have no variable cost. They have $60 in total fixed cost. Their profit is $30. Let's look at a company that all their cost is variable. They're going to sell nine tickets, nine at $10. Total revenue is $90. Now we're going to look at the variable cost. Nine times six is $54. And their profit is $36. So notice the both companies, let's go back to the original example. The original example, they both made $40 under the original example. But now when sales went down, when the number of units went down, variable cost benefited more because their income only decreased by $4. While the all fixed cost company, their income is reduced by $10. It's a huge decrease in the relationship to the variable profit decrease. Now this is a combination. It's going to be obviously in between if we sold nine tickets at $10. The total revenue is $90. Variable cost is nine times three equal to 27. Fixed cost is $30. And the profit is $33. So it's better than being fixed 100% and less beneficial than being 100% variable. Simply put, in bad time, when the number of unit goes down, the variable cost is less risky. So companies with variable cost structure, they're going to be less risky in bad time. But during good times, fixed cost company, because they're using leverage, they're going to do much, much better. Because once they exceed the fixed cost, every additional dollar they sell will be considered pure profit. Effect of cost structure on profit stability, level of fixed cost high, earning volatility high. So if you have a high fixed cost, what's going to happen? Your earning might go up substantially, or they might go down substantially. So any small increase or decrease, it's going to make a huge profit huge change in your profit. So the profit volatility going up and down is high. Therefore, you are riskier because I don't know what's going to happen. However, if your fixed cost is low, if you have a low fixed structure, your earning volatility is low. Because if you sell less, you're going to earn less money. If you sell more units, you're going to earn a little bit more, not a lot. But if you sell less, you're going to earn a little bit less. But with a high fixed cost structure, your earning will increase and decrease quite substantially, which makes you a risky company.