Question

true or false?

lower operating leverage protects the operation when sales are low

Answer 1

The statement is false.

The operating leverage formula is used to calculate a company’s break-even point and help set appropriate selling prices to cover all costs and generate a profit. The formula can reveal how well a company is using its fixed-cost items, such as its warehouse and machinery and equipment, to generate profits. The more profit a company can squeeze out of the same amount of fixed assets, the higher its operating leverage.

One conclusion companies can learn from examining operating leverage is that firms that minimize fixed costs can increase their profits without making any changes to the selling price, contribution margin or the number of units they sell.

High and Low Operating Leverage

It is important to compare operating leverage between 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 defined.

Most of a company’s costs are fixed costs that recur each month, such as rent, 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 that are only incurred when sales occur. This includes labor to assemble products and the cost of raw materials used to make products. Some companies earn less profit on each sale but can have a lower sales volume and still generate enough to cover fixed costs.

conclusion

operating leverage shows the relationship between the fixed cost and variable cost of an entity. When an operating profit is low, it means, the variable portion is higher compared to the following xer portion. When sales are low, variable cost is low and which will interest rn result in high operating leverage rather than low operating leverage. Therefore, low operating leverage doesn't protect the operation when sales are low.