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Financial Management - CAPITAL STRUCTURE THEORIES

Operating leverage - CAPITAL STRUCTURE THEORIES

   Posted On :  20.06.2018 03:10 am

High fixed costs and low variable costs provide the greater percentage change in profits both upward and downward.

Operating leverage
 
High fixed costs and low variable costs provide the greater percentage change in profits both upward and downward. If a high percentage of a firm’s costs are fixed, and hence do not decline when demand decreases, this increases the company’s business risk. This factor is called operating leverage.
 
If a high percentage of a firm’s total costs are fixed, the firm is said to have a high degree of operating leverage. The degree of operating leverage (DOL) is defined as the percentage change in operating income (or EBIT) that results from a given percentage change in sales.... In effect, the DOL is an index number which measures the effect of a change in sales on operating income, or EBIT.
 
When fixed costs are very large and variable costs consume only a small percentage of each dollar of revenue, even a slight change in revenue will have a large effect on reported profits. Operating leverage, then, refers to the magnified effect on operating earnings (EBIT) of any given change in sales...And the more important, proportionally, are fixed costs in the total cost structure, the more marked is the effect on EBIT.

One of the most dramatic examples of operating leverage is in the airline industry, where a large portion of total costs are fixed. The higher the proportion of fixed costs to total costs the higher the operating leverage of the firm.

Since a fixed expense is being compared to an amount which is function of a fluctuating base (sales), profit-and-loss results will not bear a proportionate relationship to that base. These results in fact will be subject to magnification, the degree of which depends on the relative size of fixed costs vis-a-vis the potential range of sales volume. This entire subject is referred to as operating leverage.

Thus, in general terms, operating leverage refers to the use of fixed costs in the operation of a firm. Operating leverage is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales.

The degree of operating leverage is also defined as the change in a company’s earnings before interest and tax due to change in sales. Since variable costs change in direct proportion of sales and fixed costs remain constant, the variability in EBIT when sales change is caused by fixed costs.

Operating leverage refers to the use of fixed costs in the operation of a firm. A firm will not have operating leverage if its ratio of fixed costs to total costs is nil. For such a firm, a given change in sales would produce same percentage change in the operating profit or earnings before interest and taxes.

Higher the fixed cost, higher the variability in EBIT for a given change in sales. Other things remaining the same, companies with higher operating leverage (because of higher fixed costs) are most risky.

Thus operating leverage increases with fixed costs. Operating profit of a highly leveraged (operating) firm would increase at a faster rate for any given increase in sales. Operating leverage intensifies the effect of cyclically on a company’s earnings. Operating leverage is the name given to the impact on operating income of a change in the level of output.
 
Operating leverage affects a firm’s operating profit (EBIT) while financial leverage affects profit after tax or the earnings per share. Thus operating leverage is a commitment to fixed production charges payment obligation undertaken by a company.
 

Measures of operating leverage

 
Operating leverage measures the effect of fixed costs on the firm, and that the degree of operating leverage (DOL) equals:
                                      
                                         DOL = q(p - v) divided by q(p - v) – f
 
where,
 
q = quantity,
 
p = price per unit,
 
v = variable cost per unit,
 
f = total fixed costs
 
that is:
 
Degree of operating leverage = Sales revenue less total variable cost divided by sales revenue less total cost
 
Operating leverage can also be defined as the impact of a change in revenue on profit or cash flow. It arises, whenever a firm can increase its revenues without a proportionate increase in operating expenses. Cash allocated to increasing revenue, such as marketing and business development expenditures, are quickly consumed by high fixed expenses.
 
Positive operating leverage occurs at the point at which revenue exceeds the total amount of fixed costs. Thus, the degree of operating leverage (DOL) is defined as the percentage change in the earnings before interest and taxes relative to a given percentage change in sales.
 
Thus, DOL = (% change in EBIT) / (% change in sales)
 
DOL = (changes in EBIT / EBIT) / (changes in sales / sales)
 
An alternate formula for calculating DOL is as follows
 
DOL = Contribution / EBIT = 1 + Fixed Cost / EBIT

Tags : Financial Management - CAPITAL STRUCTURE THEORIES
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