Operating Leverage

operating leverage is caused due to fixed operating expenses in the firm. It may be defined as the firms ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage is associated with investment (assets acquisition) activities.

A firm sells products for Rs. 100 per unit, has variable operating cost of Rs. 50 per unit and fixed operating cost of Rs. 50000 per year. Show the various levels of EBIT that would results from the sale of (i) 1000 units, (ii) 2000 units and (iii) 3000 units.

How to calculate OL?

The degree of operating leverage may be defined as the change in the percentage of operating income (EBIT), for the change in percentage of sales revenue. The degree of operating leverage at any level of output is arrived at by dividing the percentage change in EBIT with percentage change in sales. That is Degree of Operating Leverage (DOL) = Percentage change in EBIT / Percentage change in sales Or DOL=Contribution / Operating profit (EBIT)

Impact of OL
Operating leverage may be favorable or unfavorable. High degree of operating leverage indicates that high degree of risk. It is good when revenues are rising and bad when they are falling. Operating risk (business risk) is the risk of the firm not being able to cover its fixed operating costs. The larger the magnitude, the larger the volume of sales required to cover all fixed costs. Application of Operating Leverage
It is helpful to know how operating profit (EBIT) would change with a given change in units produced. It will helpful in measuring business risk.