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 happens due to the presence of fixed operating costs in income stream of a company.

Operating Leverage = Contribution Margin / Net Operating Income = [ ( Unit Selling Price - Unit Variable cost ) x Unit Sales ] / ( Contribution Magin - Fixed Operating Costs )

Therefore, higher the amount of fixed costs in the total cost structure, lower the denominator, and higher the degree of operating leverage.

When operating leverage exceeds 1, it means that the percentage change in net operating income exceeds the percentage change in sales. On the flip side, when there is a decline in sales volume, the percentage decline in net operating income would exceed the percentage decline in sales. This is known as business risk.

Contribution Margin = ( Sales - Variable Costs ). It represents the portion of sales left over after paying for variable costs to contribute towards fixed operating costs and profit.