Illustrate the operating leverage, Financial Management

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Q. Illustrate the Operating Leverage?

Operating Leverage: - The operating leverage perhaps defined as the tendency of the operating profit to differ disproportional with sales. It is said to survive when a firm has to pay fixed cost regardless of volume of output or sales. The firm is supposed to have a high degree of operating leverage if it employs a greater amount of fixed cost and a smaller amount of variable cost. Alternatively a firm will have a low operating leverage when it employs a greater amount of variable cost as well as a smaller amount of fixed cost. Therefore the degree of operating leverage depends upon the amount of fixed element in the cost structure.

Operating leverage in the company is a function of three factors:-

(a) The amount of fixed cost

(b) The contribution margin

(c) The volume of sales

Formulae:-

Operating leverage =    Contribution / Operating profit    or       C/OP

Utility: - The operating leverage point outs the impact of change in sales on operating income. If a firm has a elevated degree of operating leverage small changes in sales will have large effect on operating income. Alternatively the operating profit (EBIT) of such firm will rise at a faster rate than the increase in sales.

Likewise the operating profit of such a firm will suffer a great loss as compared to reduction in its sales.


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