Question

Post an explanation of the meaning of the following statement:

"Both operating risk and profit potential for an organization .... increase with an increase in the fixed-to-variable costs proportions."

Answer 1

The statement talks about operating leverage and how the use of operating leverage impacts operating risks and profit potential for a company. Operating leverage is the degree to which a company incurs a combination of fixed and variable costs. It is, in other words, the use of fixed costs over variable costs in production.

Use of operating leverage will allow the variable costs to be reduced in favor of fixed costs. This will lead to significant increase in profits for a given increase in sales. But this will happen after the breakeven point has been reached. The reason why the operating risks increases with increase in the fixed to variable cost proportions is because of the fact that fixed costs are irreversible in the short run. Higher proportion of fixed costs increases the business risk for an organization. This is because losses can be amplified during bad times and during period of economic recession when sales growth is extremely slow. Profits increases because as variable costs are reduced then each sale contributes to a higher profit margin.