Question

What is the concept of operating leverage? Describe a scenario where a high degree of operating leverage would be positive for a company and one in which it would be negative.

Answer 1

Operating leverage is the a degree to which a firm uses variable and fixed costs in production. A firm making a large amount of sales having less fixed and variable costs, provides higher gross margin and thereby higher operating leverage.

Operating leverage = Contribution margin/Net operating income

A high degree of operating leverage will be beneficial for a company which depends on sales volume to increase profitabilty. The company must generate high sales volume to cover the high fixed costs. It will not be beneficial in case where the company depends on sales of a product which is small in quantity or is customizable.