Skip to content
- 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.