Operating Leverage

Operating Leverage

Operating leverage is a measure of how much a company’s earnings before interest and taxes (EBIT) will change in response to a change in its sales.

The formula for operating leverage is:

Operating Leverage = (EBIT / Sales) / (Variable Costs / Sales)

where:

  • EBIT = Earnings before interest and taxes
  • Sales = Total sales
  • Variable Costs = Costs that vary with sales

The operating leverage tells us how much a company’s EBIT will change for every $1 change in its sales. For example, if a company has an operating leverage of 2, then a $1 increase in sales will lead to a $2 increase in EBIT.

Behavior of Operating Leverage

The operating leverage is a positive number and it increases as the proportion of fixed costs to variable costs increases. This is because the more fixed costs a company has, the more sensitive its EBIT will be to changes in sales.

For example, consider two companies, Company A and Company B. Company A has all variable costs and Company B has half fixed costs and half variable costs. If sales for both companies increase by $1 million, then EBIT for Company A will increase by $1 million, but EBIT for Company B will increase by $2 million.

This is because Company B has to pay fixed costs even if sales do not increase, so any increase in sales is first used to cover fixed costs before it can be used to increase EBIT.

MCQs on Operating Leverage

  1. Which of the following is not a factor that affects the operating leverage?
    • Fixed costs
    • Variable costs
    • Sales
    • Tax rate

The answer is Tax rate. The tax rate does not affect the operating leverage.

  1. Which of the following statements is true about the operating leverage?
    • The operating leverage is always positive.
    • The operating leverage increases as the proportion of fixed costs to variable costs increases.
    • The operating leverage decreases as the sales increase.
    • All of the above.

The answer is All of the above. The operating leverage is always positive, it increases as the proportion of fixed costs to variable costs increases, and it decreases as the sales increase.

Conclusion

The operating leverage is an important tool for understanding the operating risk of a company. Companies with a high operating leverage are more sensitive to changes in sales, so they are riskier than companies with a low operating leverage.

Here are some additional tips for using the operating leverage:

  • Use the operating leverage to compare the operating risk of different companies.
  • Use the operating leverage to evaluate the impact of changes in sales on a company’s EBIT.
  • Use the operating leverage to assess the operating risk of a new project or investment.

By following these tips, you can use the operating leverage to make informed decisions about the operating risk of a company.