Question

With regards to Operating Leverage, please explain why a company with HIGH Operating Leverage faces greater financial risk in a declining sales period compared to a company with LOW Operating Leverage. (HINT: The key here is the relation between fixed costs and variable costs.)

What does a business's Contribution Margin represent? What does the Contribution Margin have to do with Operating Leverage?

Answer 1

Operating Leverage is basically percentage of fixed costs to total costs.

When we calculate contributions and marginson any sales volume, contribution represents contribution of each unit towrads margin before deducting fixed costs. And then we calculate the break-even point ( a point or level of sales where all expenses are met from revenues earned and there is neither profit nor loss).

When we say High Operating Leverage it means that the percentage of fixed costs to total costs are high which further means that from each sold unit there should be high margin to cover the high fixed costs. If the targetted sales are not achieved then obviously,there will be loss and this is the high financial risk associated in High Operating Leverage case with sales declining.

It can be put by way ofan example:If Variable cost of a unit is $ 10 and Fixed cost is $ 2,000,000. Sale price per unit is $ 25 and planned sales are 200000 units then:

Sales=5,000,000

Variable costs=2,000,000

Contrbution: 3,000.000

FixedCosts: 2,000,000

Profit: 1,000,000

Here, the Total cost is 4,000,000 and Fixed Cost is 2,000,000 menas Operating Leverage is 50%

If we alter Fixed Cost figure to be 3,000,000 the OPerating Leverage will be 60% and profit wil be reduced to zero.

Again, in case, sales are declined from 200,000 units to 150,000, the company will suffer greater losses.

Therefore, in caseof High Operating Leverage, there is always a greater financial risk associated specially when sales decline