Question

What is meant by the term operating leverage? How is the degree of operating leverage calculated?.

What are the assumptions that underlie CVP analysis?

Answer 1

Answer 1

Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage.

The higher the degree of operating leverage, the greater the potential danger from forecasting risk, in which a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.

The Formula for Operating Leverage Is

Degree of operating leverage = Contribution margin/Profit

Total contribution margin (CM) is calculated by subtracting total variable costs from total sales

Answer 2

To summarize, the most important assumptions underlying CVP analysis are:

1)Selling price, variable cost per unit, and total fixed costs remain constant through the relevant range. This means that a company can sell moreor fewer units at the same price and that the company has no change in technical efficiency as volume changes.

2)In multi-product situations, in advance ,the product mix is known .

3)Costs can be accurately classified into their fixed and variable portions.

Critics may call these assumptions unrealistic in many situations, but they greatly simplify the analysis.

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