Below article describes the meaning of operating leverage, some of the ratios to measure operating leverage, its application and users and an illustrated example on how to compute operating leverage.
(a) Meaning of Operating Leverage:
- Refers to the existence of fixed costs in a company’s cost structure
- Is used to measure operating risk
(b) Following ratios being used to measure operating leverage:
- Fixed cost/total cost
- % change in operating income/percentage change in sales volume or
Change in profit/profit
———————————-
Change in quantity/quantity
(c) Usefulness ,Applications and other salient points to note:
- Operating leverage are important to managers and financial analysts to understand the degree of operating leverage of a company. A high operating leverage means greater fixed cost committments that have to be met even when sale volume declines [ note that high degrees of operating leverage plus highly elastic product demand will result in high levels of variability in earnings although such a condition may be inherent in the industry like the airline and auto industries.
- Note that the effects of operating leverage diminish as revenue increases above the breakeven point, since the bases to wich increases in earnings are compared become progressively larger. Therefore it is important to examine the relationship between sales and the breakeven point
- A company with a high breakeven point is quite vulnerable to economic declines. A high ratio of variable cost to total cost indicates greater stability, because variable cost can be adjusted more easily than fixed cost to meet a declin product demand.
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