Question

2. What is operating leverage and how does it influence a project?

Answer 1

Ans :

Leverage refers to amplified benefit on comparetively lower level of owner investment. Such enhancement of profit is usually seen because of fixed costs. These could be operating fixed cost or finanacial fixed cost. As sales volume increases fixed cost do not increses. Hence it results in higher level of profit.

Operating leverage refers to enhancement of profits because of fixed operating expenses. It measures a company’s fixed costs as a percentage of its total costs. It is used to evaluate the breakeven point of a business, as well as the likely profit levels on individual sales. As sales volume increases , fixed cost do not increse which results in proportionately higher profits.

Degree of Operating Leverage (DOL) calculated as below :

DOL = Contribution / EBIT or = % Change in EBIT / % Change in Sales

Higher fixed expenses indicate higher operating break even point and hence higher business risk.

Fixed operating expenses are determined by natute of business and industry. For instance, heavy engineering units would have higher level of fixed overheads, whereas service industry would have lower overheads. Thus, DOL is dictated by these factors and managers have little liberty to adjust it at their will.