Question

Companies often use leverage to augment profits. Based on what you learned this week, please explain the following in detail: With regards to Operating Leverage, please explain why a company with HIGH Operating Leverage faces greater financial risk in a declining sales period compared to a company with LOW Operating Leverage. (HINT: The key here is the relation between fixed costs and variable costs.) What does a business's Contribution Margin represent? What does the Contribution Margin have to do with Operating Leverage?

Answer 1

Operating leverage is the leveraging of fixed cost incurred in the business to generate profits. It is calculated dividing Contribution margin by Operating profit. The operating leverage helps in calculating net income by multiplying the same with sales growth. Since variable cost % is same the operating leverage is an enabler to calculate net income based on sales growth %. Operating leverage indicates the degree of risk involved in operating performance. Higher operating leverage indicates higher risk. A high operating leverage company will have lower variable cost and higher fixed cost.

When sales are moving in downward trend the decline in profits is higher for companies having higher operating leverage (because fixed costs are higher). A company will lower operating leverage will have lower decline in profits compared to a company having higher operating leverage (because fixed costs are lower)

A business contribution margin represents the margin available after deducting variable cost from sales. It helps in recovery of fixed cost and giving profits to the firm. Contribution margin helps in calculation of Operating leverage since it is calculated after deducting variable costs. The fixed costs are deducted from contribution margin to arrive at Operating Income. The difference between Contribution margin and Operating profit is fixed cost which is the leverage factor.