October 20, 2019

Operating Leverage in Finance

  • Refers to the use of fixed cost in the operation of a firm. 
  • OL may be defined as the tendency of the operating profit to vary disproportionately with sales. 
  • OL is firm’s ability to use fixed operating cost to magnify the effect of change in sales on its EBIT. 
  • OL = Contribution/Operating profit
  • OL is either favourable or adverse, it is said to be favourable if the contribution is more than the fixed cost. 
  • Need to have low OL
  • OL explains the degree of operating risk as it measures the relationship between the quantity produced and sold and EBIT. 
  • Reflects the impact of change in sales on the level of operating profits of the firm. 
  • Helps in determining business risks faced by the firm. 
  • OL is a measure of combination of FC and VC in a company’s cost structure. 
  • A company with high FC and low VC has high OL whereas a company with low FC and high VC has low OL. 
  • A company with high OL depends more on sales volume for profitability. 
  • The company must generate high sales volume to cover high FC. 

Degree of Operating Leverage

  • Percentage change in profits resulting from percentage change in the sales. 
  • Degree of OL = Percentage change in profit/Percentage change in sales
  • A firm should have high degree of OL in case it employs a large amount of FC and a small amount of VC. 
  • A firm does not like to operate under conditions of a high degree of operating leverage because a small reduction in sales leads to an excessive damage to firm’s efforts to attain profitability. 

Leave a Reply

Your email address will not be published. Required fields are marked *