Question

Operating leverage refers to the use of fixed costs to increase percentage changes in operating income when sales volume changes.

True

False

Answer 1

True

Operating leverage tells you the % change that can be achieved in operating income by changing the revenue (sales volume)

Operating leverage formula = Contribution margin/profit

Lets consider the following example of a company XYZ

1)

Quantity sold in a month =100

Contribution margin per unit is =$10

Fixed cost per month = $500

Profit of the company in example 1) = (quantity sold * contribution margin) - Fixed cost

= (100*10)-500

=1000-500

=$500

Operating leverage = contribution margin / profit = (100*10)/500= 1000/500 =2

Operating leverage of "2" indicates that for every 10% change in sales volume there will be 20% (10% * 2) change in operating income i.e., profit

lets consider a 10% increase in sales quantity in above example

2)quantity sold becomes 110 [100+ 100*10% =110]

fixed cost and contribution remains the same as in example 1)

New profit of the company is = (quantity sold * contribution margin) - Fixed cost

=(110*10)-500

=1100-500

=$600

Increase in profit is = 600-500 =100

% of increase in profit = 100/500*100 =20%

Therefore by the above example we can see that a 10% increase in sales volume increased operating profit by 20% indicating operating leverage = "2"

While calculating operating leverage fixed cost is already covered ,i.e., we get profit only after deducting fixed cost from total contribution