After reading this article you will learn about Operating Leverage:- 1. Introduction to Operating Leverage 2. Method of Computing Operating Leverage 3. Degree 4. Relationship between Operating Leverage and CVP Analysis.
Introduction to Operating Leverage:
Operating leverage arises when the operating profit varies disproportionately with the amount of sales, i.e., it appears from the existence of fixed operating expenses. Because we know operating cost consists of
(i) Fixed Cost:
Which remain fixed irrespective of the quantity that is produced?
(ii) Variable Cost:
Which vary directly with the quantity produced or with the volume of sales?
Which are partly fixed and partly variable?
Thus, the operating leverage is the firm’s ability to use fixed operating costs to magnify the effect of changes in sales on its earnings before interest and tax (EBIT). That is, with fixed costs, the percentage changes in profits accompanying a change in volume are greater than the percentage change in volume. Needless to mention here that there will be no operating leverage, if there are no fixed operating costs.
Operating leverage exists when a firm has to pay fixed cost irrespective of volume of output or sales. A firm is said to have a high degree of operating leverage if it employs a greater amount of fixed cost and a smaller amount of variable cost On the contrary, if the firm incurs greater amount of variable cost and a smaller amount of fixed cost, it produces a low degree of Operating leverage.
The effect of operating leverage can better be understood with the help of the following illustration:
(a) BEP (Break Even Points) for all the firms.
(b) Profit earned by the firms if each of them sale 1.00,000 units.
(c) What will be the impact of profit if:
(i) Sales increases by 25%
(ii) Sales decreases by 25%
From the above, it becomes crystal clear that the firm Z which has the highest amount of fixed overhead in comparison with the other firms is most vulnerable as a result of change in sales.
We also find from the above table that when sales increase from 1,00,000 units to 1, 25,000 units, profit increased by 67.57% as compared to 50% and 35.71% of firms B and A respectively. Again when the sales decrease, the percentage decrease in profit is also highest.
Method of Computing Operating Leverage:
Operating leverage can be calculated with the help of the following:
[*EBIT = Earnings before Interest and Tax. Here, Earnings mean operating profit.]
It may be mentioned here that operating leverage may be favourable or unfavourable. In other words, favourable operating leverage arises when contribution (Sales-Variable Cost) exceeds fixed cost and vice-versa in the opposite case.
Degree of Operating Leverage:
A we already know that the degree of operating leverage depends on the fixed overhead in the total cost structure of a firm.
However, the same is the function of the following:
(a) The volume of sales;
(b) The margin contribution;
(c) The amount of fixed overhead.
The Degree of operating Leverage (DOL) is the percentage change in profit arises from percentage change in sales.
It may be computed as under:
In the previous illustration, for firm C, if we calculate the DOL, the same will be represented as under:
Thus, it become clear from the above that if amount of sales changes by 1, profit will be changed by 2.7 times. This relationship is measured by DOL.
Relationship between Operating Leverage and CVP Analysis:
Operating leverage is applied for ascertaining profit planning although the CVP analysis or Break-Even analysis is used for the same purpose. It is interesting to note that the reciprocal margin of safety is expressed by operating leverage whereas Break-even analysis reveals the loss of profit at different levels of output.
We know that a low margin of safety is the product of high operating cost which reveals that the firm is unable to take the risk- bearing capacity due to sales variation. Similarly, high operating cost creates high degree of operating leverage which ultimately invites more operating risk in the field.
On the contrary, a low operating leverage presents sufficient indication by providing a high margin of safety when the volume of sales varies.