What is Operating Leverage?
What is Operating Leverage?
The breakeven point is a tool that helps a company to find out the quantity of sales that would be enough to cover its expense. Hence, it would not be wrong to say that break-even point is the point at which company sells enough units of its product to cover its expenses without making a profit or taking a loss, that is the company is operating at no profit no loss situation. As per the breakeven point, the concept of operating leverage helps to measure the degree to which a company is ready to incur a combination of fixed and variable costs.
In simple words, the Operating leverage is a measure of how revenue growth translates into growth in operating income. The basis of analysis of Operating leverage is the fixed cost and the variable cost incurred by the company. Operating leverage in a company can only be seen when they have fixed costs in the company that must be met regardless of sales volume.
Fixed costs are those costs that do not change with the level of sales. It is actually a overhead expenses which are also considered as “Sunk Costs” because no matter whether a company sells a product a not, it has to incur these costs. Variable costs are those costs that vary directly with the level of the output being sold. These costs include, the cost of raw materials, labor expenses and all those expenses which are incurred to produce a product. However, the Operating Leverage will always be higher in those companies where there is a high proportion of fixed operating costs in relation to variable operating costs.
In such companies, there is a lot of use of fixed assets in the operation of the company. Effects of operating leverage over the profitability of the company The operating leverage of a company as stated above, measures the ratio of fixed costs to variable costs. The operating leverage is measured as the ratio between the percentage change in income and the percentage change in the level of sales output. The income here “Earning Before Interest and Taxed” i.e. EBIT.
When the firm has fixed costs, the percentage change in profits due to changes in sales volume is greater than the percentage change in sales. With positive (i.e. Greater than zero) fixed operating costs, a change of 1% in sales produces a change of greater than 1% in operating profit. If the operating leverage of the company is higher, it is expected that the company can make more money from each additional sale if they don’t have to increase costs to produce more sales.
However, as per the conservative approach to operating leverage Some firms choose not to operate at high degrees of operating leverage. For instance the companies that are using expensive variable costs can be substituted for automated plant and equipment which will increase the fixed cost, but ultimately will result in the reduction of variable cost and increase in profit at large. Moreover the conservative approach Lowers the breakeven point, but also the contribution margin, which decreases risk &decreases the profit potential.
Firms or industry sectors might it be prudent to limit operating leverage The firms that are growing or at the preliminary growing stages and the industries that are labor intensive or non-cyclic in nature should limit their operating leverage. The reason behind this is that a growing company does not have much funds to incorporate in the business and in such case, it is important that the company earns profit.
Thus the company is required to limit the operating leverage because if the company in the beginning of its operations invests a large amount of money in the fixed assets, then it would become difficult for the company to earn profit as the revenues earned by the company will be used to cover the fixed costs of the company which will result in very low profit or sometimes huge losses as well. Moreover, in order to earn a profit, the company first has to go beyond the break-even point of the company which is dependent totally on the amount of the fixed costs being used in the company.
The largest is the incorporation of the fixed assets of the company, the more units of the products needs to be sold by the company to achieve the break even point. However, since the company is in the growing stage, it will be hardly possible for the company to have a high quantity of turnover which will result in the poor performance of the company. Thus, it is important for a growing company to limit its operating leverage. When the industries are labor intensive, then the industries’s main focus would be on reducing the cost. The company would always think to bring an automated system in the company for production instead of employing labor.
However, to bring an automated system in the company is very difficult because if a product is highly labor intensive, then it is expected that the company would have to invest a large amount of money in the fixed assets. The industry will be required to purchase so many expensive machines to remove the labor from the company. Making such high investment would take a lot of time to be covered by the revenues of the company and it will ultimately result in the poor performance of the industry.
Also, the companies that are non-cyclic in nature should also limit its operating leverage because the companies that are non-cyclic in nature would not be able to generate a large amount of revenues throughout the year constantly and it would not be able to cover the costs of fixed assets in a short period of time that may reduce the overall efficiency of the company.
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What is Operating Leverage?
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