Answered Essay: Companies often use leverage to augment profits. Based on what you learned this week, please explain the following in detail:

Companies often use leverage to augment profits. Based on what you learned this week, please explain the following in detail:
With regards to Operating Leverage, please explain why a company with HIGH Operating Leverage faces greater financial risk in a declining sales period compared to a company with LOW Operating Leverage. (HINT: The key here is the relation between fixed costs and variable costs.)
What does a business’s Contribution Margin represent? What does the Contribution Margin have to do with Operating Leverage?

Expert Answer

 

  1. Operating leverage, in simple terms, is the relationship between fixed and variable costs. Fixed costs are costs that are incurred regardless of the number of units sold. Variable costs change with the level of sales. A company with high operating leverage has a high percentage of fixed costs to total costs, which means more units have to be sold to cover costs. A company with low operating leverage has a high percentage of variable costs to total costs, which means fewer units have to be sold to cover costs. In general, a higher operating leverage leads to lower profits.

The more operating leverage a company has, the more it has to sell before it can make a profit. In other words, a company with a high operating leverage must generate a high number of sales to cover high fixed costs, and as these sales increase, so does the profitability of the company. Conversely, a company with a lower operating leverage will not see a dramatic improvement in profitability with higher volume, because variable costs, or costs that are based on the number of units sold, increase with volume.

  1. Operating leverage relates directly to a company’s contribution margin and breakeven point. Contribution margin is essentially a product’s selling price minus its unit-level variable cost. A product with proportionately less variable cost has a higher contribution margin. Hence, a product with a higher contribution margin corresponds with a production process that has high operating leverage – or higher fixed costs in relation to variable costs.

The degree of operating leverage of a company’s cost structure is a ratio that measure’s the sensitivity of a company’s profits to changes in sales volume. In other words, a company’s degree of operating leverage measures the degree to which a change in sales impacts profitability. In a company with high operating leverage, changes in sales volume magnify changes in profitability. Whereas a company with low operating leverage the effects of fluctuations in sales volume impact profitability to a smaller degree.

Degree of operating Leverage = % Change in operating income

% Change in sales volume

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