What is Operating leverage? How to measure operating leverage?

Leverage:
It origin from the word lever which means lifting of heavy object.

Leverage means financing the company’s asset through debt capital to earn maximum return on that investment in asset. If company’s debt capital is more than equity capital it is known as high leverage company. A company has to pay only interest to the creditors and rest of the profit is in owners’ hand

.

Importance of leverage for Company:

·         Company having more power in its hand because it raises more money through borrowed capital in comparison to share capital.

·         Company only has to pay interest to which is tax deductible.

Importance of leverage for Investors:          

·         With the help of it investors can evaluate the company’s financial position. If company pays its debt easily and in time than that company’s financial position is good.

Type of Leverages:

·         Operating Leverage

·         Financial Leverage

·         Combined Leverage

Operating Leverage:

 If there is no fixed cost in a firm there is no operating leverage.The operating cost are-

          i.            Fixed cost (it does not change with sales volume)

        ii.            Variable cost (it changes with sales volume)

       iii.            Semi-fixed or semi-variable cost (it is partly fixed or partly variable cost)

the fixed cost act as a lever with the help of it firm can maximise its operating profit by change in sales. If it is more than 1 it is considered operating leverage.High operating leverage means high fixed cost vice versa. It is use to measure business risk.

Formula:

Operating Leverage = Contribution margin / operating profit

Degree of Operating leverage = % change in EBIT / % change in sales

Example: A company sells its product at Rs.80 per unit. The variable cost of a product is Rs.60 per unit and fixed cost is Rs.30000 yearly. Find out the operating leverage if company produces 5000 and 3000 unit from 2000 unit of a product.

  Solution:

Particular	2000 units (Base )	3000 units	1000 units
Sales	1,60,000	2,40,000	80,000
Variable Cost	(1,20,000)	(1,80,000)	(60,000)
Contribution Cost	40,000	60,000	20,000
Fixed Cost	(30,000)	(30,000)	(30,000)
EBIT	10,000	30,000	-10,000

Degree of Operating leverage = % change in EBIT / % change in sales

3000 units

% change in EBIT = (30,000-10,000)/10,000 =2

% change in sales unit = (3000-2000)/2000 =0.5

=2/0.5

=4

4 >1 so, it is high operating leverage.

1000 units

% change in EBIT = (-10,000-10,000)/10,000 = -2

% change in sales unit = (1000-2000)/2000 = -0.5

= -2/-0.5

= 4

4 >1 so, it is high operating leverage.

Interpretation:If a firm increases 0.5% in sales then 4% increase in degree of operating leverage and vice versa.

Example: Find out operating leverage from the following information:

Particular	Amount
Sales	2,50,000
Variable Cost	80,000
Contribution margin	1,70,000
Fixed Cost	50,000
EBIT	1,20,000

Solution:

Operating Leverage = Contribution margin / operating profit

= 1, 70,000/1, 20,000

=1.41

1.41 >1 so, it is high operating leverage.

Example: Find out the degree of operating leverage with the help of given  information about the company X and Y:

·         Sales in unit X and Y are-  50, 000 and 51, 100

·         Fixed cost of X and Y are-  60, 000 and 45, 000

·         Variable cost  of X and Y are - Rs. 32, 000 and Rs. 40, 900

·          The selling price per unit is Rs.10 for product X and Y.

Solution:

Particulars	X  (Rs.)	Y (Rs.)
Sales	5, 00,000	5, 11,000
Less: variable cost	32, 000	40, 900
Contribution margin	4, 68,000	4, 70,100
Less: fixed cost	60, 000	45, 000
Earnings before interest and tax	4, 08,000	4, 25,100

Degree of Operating Leverage :

= Contribution margin / EBIT

X = 4, 68,000 / 4, 08,000

= 1.15

Y = 4, 70,100 / 4, 25,100

= 1.11

Company X has higher degree of operating leverage in comparison to company Y which means company X has higher volatility and small changes in sales volume affect the income.