Description: This ratio reveals the extent to which fixed costs are required to create profits, by comparing the amount of fixed costs to operating income. It is particularly useful when a company is considering the acquisition of more fixed assets to replace variable costs, such as manual labor in the production process, and wants to find out the extent to which this will add to its fixed cost structure. This ratio is works well when combined with breakeven analysis, which is heavily influenced by changes in fixed costs.
Formula: Subtract all variable expenses from sales, and then divide this amount by operating income. Under the most strict definition of variable expenses, this will likely only include direct materials costs and commissions – all other expenses are fixed in the short run, and can be included in the ratio as fixed costs. The formula is as follows:
Sales – Variable Expenses
Operating Income
Cautions: Be careful to examine all costs used in the numerator of the ratio, and include them as fixed costs when in doubt as to their fixed or variable nature. Though all costs are variable in the long term, most can only be changed with some difficulty in the short term, and so should be itemized as fixed costs. Even the wages paid to direct labor personnel are not usually variable, since most companies do not vary their direct labor staffing levels unless there are marked changes in the level of production.