Question

Is operating leverage a good thing? Why or why not? How can we improve a company’s operating leverage?

Answer 1

Operating leverage (OL) means high proportion of fixed asset (FA) over the variable operating cost.

This shows how the company uses its fixed assets to generate profit margins.

FA are higher in proportion to variable cost, shows higher OL, On the other hand higher portion of VC will generate lower the OL, which means smaller profit from incremental sales.

Operating leverage effects when company incur expenses over the fixed cost during the production of goods.

In case of High OL Company, it can earn large profit on each sales but at least company must cover its FC first.

Higher degree of OL creates sensitivity to change in revenue, more sensitive OL shows riskier.

In case of Lower OL company, they are highly depending up on its variable cost, company earn small amount of profit on its incremental sales. This type of company can easily earn profit from low sales volume.

Intel, Microsoft are few example of focusing OL - they spend more focus on FA, which in turn shows lower the profit margin in startup, but most profitable in long run.

Degree of Operating Leverage is to be computed by using following formula:

Sales – Variable Cost      =             Fixed cost      .

Profit margin                                      Profit margin

Illustrated as below:                                        Formula:

Fixed cost	180000
Cost per unit	2
No of unit sold	30000
Sales rate	50

( 30000 * 50 ) - ( 30000 * 2 )

( ( 30000 * 50 ) - ( 30000 * 2 ) ) - 180000

                                                                               

                                      = 114 % ~ 1.14