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Operating Leverage

Operating Leverage Assignment / Homework Help
Operating leverage is the leverage associated with investment activities. Operating leverage can be determined by the relationship between a company's sales revenue and its earnings before interest and taxes. EBIT is also termed as operating profit. Operating leverage results from the existing of fixed operating expenses. The operating leverage can also be said as the firm's ability to use the fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. A firm employs or invests in fixed assets hoping that the profits generated from those assets would cover the fixed costs of operating them as well as the variable costs.

Example:

A firm selling price of its product is $100 per unit. The variable cost per unit is $50 and the fixed operating costs are $50,000 per year. Let us evaluate the EBIT resulting from sale of 1) 1000 units 2) 2000 units & 3) 3000 units.

Operating Leverage

Results:

From case 2 to case 3: An increase in sales by 50% (from $200,000 to $300,000) resulted in an increase in EBIT by 100% (from $50,000 to $100,000).

From case 2 to case 1: A decrease in sales by 50% (from $200,000 to $100,000) resulted in a decrease in EBIT by 100% (from $50,000 to $0).

This relationship between the increase/decrease in sales and change in EBIT is called as operating leverage.

Degree of Operating leverage

Degree of operating leverage can be expressed as the percentage change in EBIT divided by the percentage change in sales. If the proportionate change in EBIT as a result of a given change in sales is more than the proportionate change in sales, operating leverage exists.

Operating Leverage

If DOL > 1, operating leverage exists.

The greater the DOL, the higher is the operating leverage.

Calculation of degree of operating leverage:

Example:

With the same figures given above, we can calculate the operating leverage.

Percentage change in EBIT = ($100,000 - $50,000)/$50,000 x 100 ⇒ 100%

Percentage change in Sales = ($300,000 - $200,000)/$200,000 x 100 ⇒ 50%

DOL = 100% ⁄ 50% = 2

An operating leverage of 2 indicates that for every $1 change in sales there would be $2 change in EBIT in the same direction.


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