Question

What is operating leverage? How can the degree of operating leverage be used in analyzing change in sales?

Answer 1

Ans- Operating Leverage defination: Operating leverage is a measure of how sensitive the operating income is to the change in revnues. Alternatively Operating leverage can be defined as the capability of the firm to use its fixed expenses to generate better returns.

The Degree of Operating Leverage is the leverage ratio that sums up the effect of an amount of operating leverage on the company's earnings before interests and taxes. Operating Leverage takes into account the proportion of fixed costs to variable costs in the operation of a business. If the degree of operating leverage is high, it means that the earnings before interest and taxes would be unpredictable for the company even if all the other factors remain the same.

The formula used for determining the Degree of Operating Leverage is as follow:

DOL= %Change in EBIT/ % Change in Sales

The Degree of Operating Leverage Ratio helps a company in understanding the effects of operating leverage on the company's probable earnings. It is also important in determining a suitable level of operating leverage which can be usedin order to get the most out of the company's Earnings before interest and taxes. If the operating leverage is high, then a smallest percentage change in sales can increase the net operating income. The net operating income is the amount of income that is left after payments of fixed cost are made,regardless of how much sales has been made. Since the Degree of Operating Leverage helps in determining how the change in sales volume would affect the profits of the company, it is important to ascertain the value of degree of operating leverage in order to minimize the losses to the company.