Introduction
Operating
leverage is a good indicator of the effect of the firm’s variable and fixed
costs to its profitability as the sales volume goes up. Seeing operating
leverage by means of numerical lessons will assist students and working people
to understand its practical effects better. Royal Research is a company that
offers detailed academic writing services in finance subject to enhance their
performance in their assignments. In this article, we will use practical
examples of operating leverage to demonstrate how it affects the performance of
the business.
What is Operating Leverage?
The
Operating Leverage reflects the ability of a company’s operating income to
react to fluctuations in sales volume. Fixed cost proportion in operating
expenses is higher for companies with high operating leverage as they are more
sensitive to sales.
Calculating Operating Leverage
The
formula for operating leverage is:
Operating
Leverage= (%change in Operating Income) / (%change in Sales)
Alternatively,
it can be expressed using the contribution margin and operating margin:
Operating Leverage =% of Contribution Margin / % of Operating Margin
Numerical Example 1:
Scenario:
Revenue:
$1,000,000
Variable
Costs: $600,000
Fixed
Costs: $200,000
Step-by-Step
Calculation:
Calculate
Contribution Margin:
Contribution
Margin= (Revenue−Variable Costs)/Revenue
Contribution
Margin= ($1,000,000- $600,000)/1,000,000
Contribution
Margin=0. 4 or 40%
Calculate
Operating Margin:
Operating
Margin= (Revenue−Variable Costs−Fixed Costs)/Revenue
Operating
Margin= (1,000,000−600,000−200,000)/1,000,000
Operating
Margin= 2 or 20%
Calculate
Operating Leverage:
Operating
Leverage =% of Contribution Margin / % of Operating Margin
Operating
Leverage=(40/20)=2
Interpretation:
Every
1% increase in sales make operating income increase by 2%. This implies that
the level of the operating leverage for the company is moderate, which means
that the company is sensitive to variations in the volume of sales.
Numerical Example 2:
Scenario:
Revenue
Year 1: $800,000
Revenue
Year 2: $1,000,000
Variable
Costs: 60% of the revenue
Fixed Costs: $200,000
Step-by-Step
Calculation:
Calculate
Initial Operating Income:
Year1,
Variable Costs=0.6×800,000=480,000
Year
1, Operating Income=800,000−480,000−200,000=120,000
Calculate
New Operating Income:
Year
2, Variable Costs=0.6×1,000,000=600,000
Year 2, Operating Income=1,000,000−600,000−200,000=200,000
Calculate Percentage Change in Sales and Operating Income:
%Change in Sales= (1,000,000−800,000)/800,000×100=25%
%Change in Operating Income=
(200,000−120,000)/120,000×100=66.67
Calculate Operating Leverage:
Operating Leverage= (%Change in Operating Income)/
(%Change in Sales)
Operating Leverage=66.67/25=2.67
Interpretation: Hence, a greater degree of operating leverage 2.67 shows that operating profit of the company is highly sensitive to even small changes in volume of sales. The 25% rise of sales resulted in 66% of the rise. 67% increase in operating income shows that the fixed cost margin is an important element of profit margins.
Conclusion
It
is essential to have an understanding of operating leverage and its calculation
in order to have a good financial management and a strategic planning. The
operating leverage has been demonstrated mathematically using the numerical
examples below. This is to enable firms to weigh the risks involved in sales
and in making decisions. We at Royal Research are committed to creating an
environment where students can learn the intricacies of financial concepts
through our academic writing service. When it comes to essays, dissertations,
assignments, reports, or case studies, our experienced experts are here to give
you the essential steps.
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