Question

leverage relates to the amount of fixed costs the company has; when might the company be better off with high fixed costs? When would they be better of with variable costs?

Answer 1

Operating leverage relates to the amount of fixed costs the company has.

The company is in much better position with high fixed costs or high operating leverage when the economy is good, the firm is generating regular sales and is able to cope up with business cycles. This means that if high amount is spent in fixed costs, it creates high sensitivity in revenue changes. Any additional revenue will impact the ratios in positive way as there will be less additional expenses. If there is no extra cost incurred in production and additional revenue is achieved, it is win-win for the company.

But on the other hand , when there is more of variable costs, it is easier to find cheap financing as creditors look for the firms with low operating leverage. Another benefit of more of variable costs is that in the case of economic turmoil of the company, they can survive it with cost reduction by decreasing expenses in variable costs whereas it is very difficult to reduce expense in fixed cost as they might be sunk cost or can be recovered after scrapping or selling off.