Question

In CVP analysis, contribution represents the unit selling price less the unit variable cost. How does it relate to the concept of operating gearing

Answer 1

Operational gearing is another name for Operational leverage. The degree of operating leverage is generally used to measure the change in operating income resulting from the change in sales level of the company.

It measures the level of change in operating income to the change in the sales revenue of the firm. It explains how revenue growth translates into growth in operating income.

The higher the contribution margin is, the faster the profits will increase with increase in sales.

However, there is an assumption under CVP analysis that, costs and revenues will remain linear throughout the range of activity and there are constant costs and sales prices. So, under CVP analysis, contribution margin is a fixed quantity and does not changes with sales. Thus, operating leverage will change only when the sales changes. An increase in sales will lead to increase in contribution margin, resulting in higher operating leverage.