"Operating leverage" refers to:
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Operating leverage is the extent to which changes in sales revenues affect operating profits.
"Operating leverage" refers to the extent to which changes in sales revenues affect operating profits. It measures the sensitivity or responsiveness of operating profits to changes in sales.
When a company has high operating leverage, it means that a small change in sales can have a significant impact on operating profits. Conversely, when a company has low operating leverage, it means that a substantial change in sales is required to significantly affect operating profits.
Operating leverage is influenced by the cost structure of a business. Specifically, it relates to the proportion of fixed costs versus variable costs in the company's operations. Fixed costs are expenses that do not vary with changes in production or sales levels, such as rent, salaries, and depreciation. Variable costs, on the other hand, change in direct proportion to changes in production or sales, such as raw materials and direct labor.
To understand the impact of operating leverage, consider the following example:
Let's assume Company A and Company B are competitors in the same industry. Both companies have the same level of sales and the same variable costs. However, Company A has higher fixed costs (e.g., higher rent, more employees) compared to Company B.
Now, if there is a 10% increase in sales for both companies, Company A, with higher operating leverage, will experience a larger increase in operating profits compared to Company B. This is because the higher fixed costs of Company A remain the same, while the increase in sales leads to higher revenue without a significant increase in variable costs. Therefore, the incremental revenue from the increased sales contributes more to the operating profits of Company A.
Conversely, if there is a 10% decrease in sales, Company A will experience a larger decrease in operating profits compared to Company B. The fixed costs of Company A remain the same, but the decrease in sales leads to lower revenue without a significant reduction in variable costs. As a result, the decrease in revenue has a greater negative impact on the operating profits of Company A due to its higher fixed costs.
In summary, operating leverage reflects the sensitivity of operating profits to changes in sales. It is determined by the proportion of fixed costs to variable costs in a company's cost structure. A higher operating leverage indicates that a company's operating profits are more sensitive to changes in sales, while a lower operating leverage suggests less sensitivity to sales fluctuations.