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Explain Operating Leverage. How is it computed? What does high/low operating leverage indicate?
Operating leverage works on fixed cost as well as variable costs. It analyzes both of the costs and it remains in the company which has the highest proportion of fixed operating cost in relation to variable operating costs. The company uses fixed assets in operation of the company or vice versa. The company which is dealing in high operating leverage makes more money from additional sales if the company's cost doesn’t increase to produce more sales. For example the software developing company's cost structure remains fixed and limited to the development and marketing cost. It doesn't matter how many components they sell the cost remain fixed. It helps the investor in dealing with the information on the risk analysis of the company. High operating leverage sometimes helps benefiting companies and sometimes remain vulnerable to sharp economic and business cycle swings.
How is it computed?
Operating leverage is highest in companies which got fixed operating cost in relation to variable operating cost. It tells investor about the companies position and the risk profile of the company. It is measured when a company has fixed costs that are regardless the sales volume. When company has fixed cost then the percentage change in profits due to changes in sales volume is greater than the percentage change in sales. The computation of this is known as degree of operating leverage (DOL) which gives the extent to which operating profits change as sales volume changes. It is given as:-
DOL (Degree of operating leverage) = %age change in income / %age change in sale
What does high/low operating leverage indicate?
Operating leverage indicate about the company and its future profitability. It also help in assessing the level of risk which has been offered to the investors. Through this investors can estimate the profitability under certain conditions. High operating leverage indicates profits and it tells about the company's more money making policies from each additional sale if the increase cost doesn't increase to produce more sales whereas low operating leverage indicate the declining of profit margins and decreasing in earnings.
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