Link between operating lavarage and BEP

1. LINK BETWEEN
OPERATING LAVARAGE AND BEP
Prepared by Iryna Progoniuk

2. 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:
BIP =
Fixed cost
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.)

3. 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:
OL =
Quantity x (Price – Variable Cost per Unit
Quantity x (Variable Cost per Unit) – Fixed Operating Cost

4. 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.

5. PRACTICAL EXAMPLE
• 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
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