OPERATING LEVERAGE

The employment of an asset or source of funds for which the firm has to pay a fixed cost or
fixed return may be termed as leverage. If the EBIT (earnings before interest and tax)
exceeds the fixed return requirement, the leverage is called favourable. When they do not,
the result is unfavourable leverage.
There are two types of leverage- Operating leverage and financial leverage.
The leverage associated with investment (asset acquisition) activities is referred to as
operating leverage. Operating leverage is determined by the relationship between the firm’s
sale revenues and its earnings before interest and tax (EBIT). EBIT is also known as
operating profits. The leverage associated with financing activities is called financial
leverage. Financial leverage represents the relationship between firm’s EBIT and earnings
available for ordinary shareholders. When they evaluate whether they can increase
production profitably, they address operating leverage. If they are expecting taking on
additional debt, they have entered the field of financial leverage. Operating leverage and
financial leverage both heighten the changes that occur to earnings due to fixed costs in a
company's capital structures. Use of debt, or leverage, increases the company's risk of
bankruptcy. It also upsurges the company's returns, specifically its return on equity. It is a
fact because, if debt financing is used rather than equity financing, then the owner's equity is
not diluted by issuing more shares of stock.

OPERATING LEVERAGE
There are essentially two types of costs in a company's cost structure -- fixed costs and
variable costs.
What are fixed costs?
Well as the name itself suggests, these costs are fixed which will not change irrespective of
the number of units produced.
E.g. Rent of the factory which an organization pays on a monthly basis will remain fixed
irrespective of the fact that they produce 500 or 5,000 units of 5,00,000 units of the product.
What are variable costs?
As opposed to fixed costs, variable costs vary with the number of units produced. In other
words, there are directly proportionally with units produced.
E.g. Raw materials consumed in order to produce the finished product. Say the company is
in the business of assembling a mobile phone and battery is a raw material for the company.
In this case, cost of batteries consumed will be a variable cost for the company as the
volume is dependent directly on the volume of total production of mobile phones in a given
period of time.

OPERATING LEVERAGE measures the company’s fixed costs as a percentage of its total
costs. A company with higher fixed cost will have higher Leverage as compared to a
company having higher variable cost. What does operating leverage really mean? It means
that if a firm has high operating leverage, a small change in sales volume results in a large
change in EBIT and ROIC( return on invested capital). In other words, firms with high
operating leverage are very sensitive to changes in sales and it affects their bottom line
quickly.
If a business firm has high fixed costs and their costs do not decline as demand declines,
then the firm has high operating leverage which means high business risk.
It is essential to compare operating leverage among companies in the same industry, as
some industries have higher fixed costs than others. The concept of a high or low ratio is
then more clearly determined.
Most of a company’s costs are fixed costs that occur regardless of sales volume. As long as
a business earns a substantial profit on each sale and sustains adequate sales volume, fixed
costs are covered and profits are earned. Other company costs are variable costs incurred
when sales occur. The business earns less profit on each sale but needs a lower sales
volume for covering fixed costs. However, the business does not generate greater profits
unless it increases its sales volume.
For example, a software business has greater fixed costs in developers’ salaries, and lower
variable costs with software sales. Therefore, the business has high operating leverage. In
contrast, a computer consulting firm charges its clients hourly, resulting in variable
consultant wages. Therefore, the business has low operating leverage.
You can compare the operating leverage for a capital intensive firm, which would be high, to
the operating leverage for a labour intensive firm, which would be lower. A labour intensive
firm is one in which more human capital is required in the production process. Mining is
considered labour intensive because much of the money involved in mining goes to paying
the workers. Service companies that make up much of our economy, such as restaurants or
hotels, are labour intensive as well. They all require more labour in the production process
than capital costs. In difficult economic times, firms that are labour intensive typically have
an easier time surviving than capital intensive firms.
Lower operating leverage –
This implies lower fixed costs and higher variable costs. In this case, a company has to
achieve minimum sales which will cover its fixed costs. Once it crosses the break-even point
where all its fixed costs are covered, it can earn
Once it crosses the break-even point where all its fixed costs are covered, it can earn
incremental profit in terms of Selling Price minus the Variable Cost which will not be very
substantial as the variable cost itself are high.
When the operating leverage is low and fixed costs are lower, we can also safely conclude
that the break-even units which a company needs to sell in order to suffer a no loss & no
profit equation will be comparatively lower.
Higher operating leverage –
This implies lower variable costs and higher fixed costs. Here, as the fixed costs are higher,
the break-even point will be higher.
The company will have to sell more number of units to ensure no loss & no profit situation.
On the other hand, the advantage here is that after the break-even is achieved, the company
will earn a higher profit on every product as the variable cost is very low.
The company will have to sell more number of units to ensure no loss & no profit situation.
On the other hand, the advantage here is that after the break-even is achieved, the company
will earn a higher profit on every product as the variable cost is very low.
Companies generally prefer a lower operating leverage so that even in cases where the
market is slow it would not be difficult for them to cover the fixed costs.

DEGREE OF OPERATING LEVERAGE

Degree of operating leverage = Sales – Variable cost
(DOL) Sales-Variable cost – fixed cost

Example –
A firm sells a product for Rs. 100 per unit, has a variable cost of Rs. 50 per unit and fixed
cost of Rs. 50,000 per year. Find DOL if company sold 3000 units
Sale decrease by 10% Sale = 2000 units Sale increase by 10%
(Sale – 1800 units) (Sale – 2200 units)
 Sales 180000 200000 220000

Less Variable cost 90000 100000 110000

= Contribution 90000 100000 110000

Less fixed cost 50000 50000 50000

= EBIT 40000 50000 60000

DOL = Sales – variable cost = 100000 = 2

EBIT 50000
This means that if we increase sales by 1% then EBIT will increase by 2% and also if sales
decrease by 1% the EBIT will decrease by 2%. Let us see this by calculating the same. If
we increase
when we increase or decrease sale by 10%i.e. 200 units (10% of 2000 units = 200 units) the
revenue has gone up or come dow by 20% i.e. Rs. 10000 (20% of Rs. 50000 = Rs10000)
Uses of Operating Leverage
Operating leverage is one of the procedures to measure the impact of changes in sales
which lead for change in the profits of the company. If there is any change in the sales, it will
lead to corresponding changes in profit.
Operating leverage assists to identify the position of fixed cost and variable cost.
Operating leverage defines the overall position of the fixed operating cost.
The degree of operating leverage is directly proportionate to a firm's level of business risk,
and therefore it serves as a proxy for business risk.
Effects of Operating Leverage
A high operating leverage entails that company has increased production without investing in
additional fixed costs. As production rises, managers are in effect spreading fixed costs
across a greater number of units, so the additional units have a lower ratio of fixed costs to
total costs. When demand for company product increases, then experts can easily ramp up
production by increasing variable costs; Company's fixed assets allow to magnify production.
Managers can increase production as long as their higher variable costs do not cause total
costs to exceed their sales revenues. However, at the time of a recession, high operating
leverage is risky.

PRACTICAL QUESTION

1. A firm sells a product for Rs. 240 per unit, having a variable cost of Rs. 180 per unit
and fixed cost of Rs. 10000. Find DOL if company sells 500 units and verify your
answer

2. A firm sells a product for Rs. 90 per unit, having a variable cost of Rs. 40 per unit and
fixed cost of Rs. 25000. Find DOL if company sells 1000 units and verify your answer
 Solution

Total Sales (in Rs.) - Total Variable Cost (in Rs.)

DOL =
Total Sales (in Rs.) - Total Variable Cost (in Rs.) - Fixed Cost (in Rs.)

1.
DOL = 30000 = 1.5
20000

To Prove DOL :
If sales increase or decrease by 1% - EBIT will increase or decrease
respectively by 1.5%
For convenience let us take 10%
If sales increase by 10% - EBIT will increase by 15%
To increase sale by 10% we need to sell 50(500*10/100) more units
If our profit increases or decreases by 15% (i.e 20000*15/100 = 3000) our DOL is correct
At 450 units At 500 units At 550 units

Sales 108000 120000 132000

- Variable Cost 81000 90000 99000
- Fixed cost 10000 10000 10000
EBIT (Profit before
interest and tax)) 17000 20000 23000

2.

DOL = 50000 =2
25000
To Prove DOL :
If sales increase or decrease by 1% - EBIT will increase or decrease respectively by 2%
For convenience let us take 10%
If sales increase by 10% - EBIT will increase by 20%
To increase sale by 10% we need to sell 100(1000*10/100) more units
If our profit increases or decreases by 20% (i.e 25000*20/100 = 5000) our DOL is
correct
At 900units At 1000 units At 1100units

Sales 81000 90000 99000

- Variable Cost 36000 40000 44000
- Fixed cost 25000 25000 25000
EBIT (Profit before interest
and tax)) 20000 25000 30000