OPERATING LEVERAGE - Accounts and Finance for Managers

Operating Leverage is connected with the acquisition of assets where as the financial Leverage is connected with the Financing of activities.

Operating leverage: It is a relationship in between the Sales and Earnings before interest and taxes.

Financial leverage: It is a relationship in between the Earnings before interest and taxes and Earnings per share.

Operating and Financial: In the Operating and Financial leverages, the EBIT is found as a common phenomenon. During the first part of the chapter, let us discuss about the operating leverage. It emerges only due to Fixed operating expenses. By and large, the expenses are classified into two categories viz Fixed and Variable in categories for the analysis of leverage.

  • Operating Leverage is defined as the ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes.
  • Described as % change in profits accompanying the % change in volume.
  • "The firms' ability to use fixed operating costs to magnify the effects of changes in the sales on its earnings before interest and taxes".
  • A firms sells products for Rs 100 per unit has variable operating costs of Rs. 50 per unit and fixed operating cost of Rs. 50,000 per year. Show the various levels of EBIT that would result from sale of i) 1000 units ii) 2000 units iii) 3000 units.

OPERATING-LEVERAGE

From the above illustration, it is obviously understood that from the two different cases.
Case A illustrates that 50% increase in the volume of sales led to 100% increase in the volume of profit.
Case B highlights that 50% reduction in the volume of sales led to 100% decrease in the volume of profit.
It is clearly evidenced that % change in the volume of sales is less than the % change in the volume of profit.
The next step is to define the Degree of Operating Leverage (DOL)

  • DOL is the measure reveals the extent or degree of operating leverage.
  • When Operating leverage exists ?

Proportionate change in EBIT of a given change in sales is greater than the Proportionate in sales

Degree of Operating Leverage (DOL)

By algebraically proven and the following formula has derived to determine the DOL through the alternate methodology

DOL= (Total Contribution (Base Level)/ EBIT ( Base Level))

To determine the degree of the operating leverage, from the above illustration which is applied
DOL= Rs.1,00,000/Rs.50,000= +2
The answer of the DOL has been checked in both directions to the direct methodology.
If there is no fixed operating cost in the manufacturing enterprise ? What would be the Degree of Operating leverage ?

Operating leverage

Calculate the Degree of operating leverage

DOL= Total Contribution (Base Level)/ EBIT ( Base Level)

To find out the EBIT = Sales -VC=Contribution i.e. EBIT

DOL= R400 Rs.400 =+1

In the alternate methodology, the DOL is as follows:

DOL= % change in EBIT % change in Sales = 10% 10 =+1

When there is no fixed cost in the cost of operations means that the firm does not have operating leverage in its operations.
The operating leverage is related to the operating risk of the investments, which means that fixed cost of operations of the enterprise. It highlights that greater the fixed cost of operations means that higher the operating risk; which means that greater will be break even point and vice versa. The greater volume of fixed cost of operations are found to be more favorable only during the occasion of greater volume of earnings, unless otherwise the dominance of fixed cost of operations are found to be undesirable to magnify the volume of EBIT.


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