Operating Leverage – Short Essay

Firms incur fixed and variable costs. In the short run, any firm with fixed operating costs, regardless of volume, has operating leverage. Businesses expect sales to produce revenues enough to cover all fixed and variable costs. The fixed costs remain the same despite an increase or decrease in volume whereas operating costs vary with the level of output.  Operating leverage computes the extent to which a business can raise operating income by increasing revenue.

It indicates how much an entity’s operating revenue would grow as the sales increase. If a business has a greater proportion of fixed costs than the variable costs, then it has greater operating leverage. Operating leverage is a “Proportion of fixed costs versus variable costs in a company’s cost structure and the relative impact on profit given a change in sales” (Ruetschi, 2022, p. 46). To calculate operating leverage, the first step is finding the earnings before interest and tax, calculating the percentage change in sales output, and then dividing the value from step one by the percentage change in sales in sales output.

Break-even analysis is applied in the study of operating leverage. It entails studying the relationship between fixed costs, variable costs, sales volume, and profits (Khan & Jain, 2014). The break-even point is the intersection between the total costs line and the total revenues line and is the sales point a firm needs to get to ensure revenues cover operating costs. Another crucial concept is the degree of operating leverage (DOL) that quantifies the sensitivity of a firm’s operating profit to a change in its sales. If company Z sells 500,000 products at $6 each with fixed costs of $800,000 and the variable cost of $0.05 per unit. The operating leverage would equal 1.37%; (500,000 * {$6-$0.05}) / (500,000* {$6-$0.05}-$800,000). Thus, a 10% increase in revenue would increas the operating income by 13.7%.

References

Khan, M. Y., & Jain, P. K. (2014). Financial management: text, problems and cases. Mcgraw Hill Education.

Ruetschi, J. (2022). Transforming Financial Institutions: Value Creation Through Technology Innovation and Operational Change. Wiley & Sons Canada, Limited, John.