Question

Describe what operating leverage is, and the difference between the degree of pre-tax cash flow operating leverage and the degree of accounting operating leverage (use formulas in your explanations). Under what conditions would a corporate decision-maker be more interested in the accounting metric? (maximum length guide: about 150 words)

Answer 1

Operating leverage means that the amount of fixed cost that is included in the overall cost of operations of a company and the company needs to always bear those fixed cost because fixed cost are always occouring to the company even if the company is not able to make profit.

These operating leverage needs to be lower in order to help the company in generating a large amount of profit because these operating average will be very important in finding out the break even point of the company.

Degree of the pre tax can be calculated using

=[% change in earning before interest and tax/% change in sales]

This will determine the impact of change in sales on the company's earnings.there is a difference between the degree of accounting operating leverage and pre tax operating leverage because accounting operating leverage will be taking into consideration of different factors like interest and taxes whereas normal pretax cash flows operating leverage will be not taking into account any kind of interest and taxes.