Operating leverage is related to the cost structure of a firm. It uses fixed costs incurred by the firm to maximize the returns. A cost is considered fixed when it remains the same even with a change in the output.
In short, fixed costs are not affected by the change in production volume. Operating leverage makes use of these characteristics to make appropriate decisions.
Operating leverage results when there is a change in the operating profit of the firm due to the change in sales revenue.
The degree of change is determined by the quantum of fixed costs. Operating leverage occurs when the change in sales brings about more than a proportional change in operating profits.
This type of leverage may use cost-volume-profit analysis or break-even analysis for this purpose.
Operating Leverage = Contribution or (Sales – Variable Cost) / Operating Profit or (Contribution – Fixed Cost)
According to Brigham, “if a high percentage of a firm’s total costs are fixed costs, then the firm is said to have a high degree of operating leverage.”
Characteristics of Leverage
The following are the salient characteristics of OL:
1) Importance of Fixed Costs:
Operating leverage depends on the existence of fixed costs. If there are no fixed costs, there cannot be operating leverage for that business.
2) Direct Relationship between Operating Leverage and Break-Even Point:
The degree of OL is highly close to the break-even point. Therefore, it shows that there is a direct connection between the operating profit and the break-even point.
Measures of Operating Leverage
It can be measured in the following three ways:
1) Fixed Costs to Total Costs:
A higher ratio of fixed costs to total costs may signal lower quality of earnings i.e., profit, as it may lead to uncertainty of the quantum of earnings.
2) Percentage Change in Operating Income to the Percentage Change in Sales:
A higher ratio on this account (percentage change in operating income to the percentage change in sales) also indicates varying unsteady earnings.
3) Net Income to Fixed Costs:
If the ratio between net income and fixed costs declines, it signals low-quality earnings i.e., profit; due to the higher chances of instability.
For high-quality earnings, variable costs should constitute a higher percentage of the total cost as it would ensure that the costs fluctuate with the change in volume. It also helps in keeping lower break-even points as a higher break-even point makes a firm more susceptible to changed circumstances.
Impact of Market Conditions on Operating Leverage
O.L is affected by market conditions in the following ways:
1) Regular Market Conditions:
When the market is normal, the company that has a lot of operating leverage is in a better position. If the firm has an operating leverage of 2. then every 100% increase in its revenue will lead to a 200% increase in its operating profit. Similarly, any decline in the sales revenue will also have a double negative impact on operating profit. However, since regular market conditions generally lead to a smooth increase in sales revenue, firms with higher O.L tend to perform better.
2) Impact of Inflation:
Inflation refers to the increase in the general price level. During inflationary periods, every firm’s revenue increases. This situation is beneficial for firms with higher operating leverage as the increase in revenue leads to a higher-than-proportional increase in operating profits. However, in deflationary conditions, such tend to suffer heavily as the decline in revenue causes a higher decline in operating profits. Firms with lower O.L during inflation tend to remain relatively unaffected by changes in revenue.
Capital-intensive firms tend to have a higher O.L as there are higher fixed expenses and lower variable costs. Whereas in the case, the firms using less automated machines, this generally leads to a lower O.L., i.e., there are fewer fixed expenses and higher variable costs.
Costs Associated with Inventory– CLICK HERE