Question

How does a company's operating leverage effect its profitability? 200 words

Answer 1

Operating leverage:

Operating leverage reflects the relationship between variable and fixed costs in a company’s cost structure.

High operating leverage:

Means large proportion of the costs are fixed costs and it implies that the lower proportion are variable costs.

Low Operating Leverage:

Means lower proportion of the costs are fixed costs and the larger proportion are variable costs.

Operating leverage effect on companies profitability

1. Lets assume a company with high operating leverage which means that the company has higher fixed costs and lower variable costs.

***[Lower variable cost means higher contribution margin]

In this case, the firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs [since it has higer contrinution margin].

2. Now, Lets assume a company with less operating leverage which means that the company has lower fixed costs and higher variable costs.

***[Higher variable cost means lower contribution margin]

In this case, the firm earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order to cover its lower fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn outsized profits if it can generate additional sales [Because of lower contribution margin]

Conclusion:

When operating leverage is high, a change in sales results in a large change in profit (loss). On the other hand, when operating leverage is low, a change in sales results in a small change in profit (loss).