Page 169 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes 7.2.2 Fixed Cost and Operating Leverage

Changes in fixed operating costs affect operating leverage. Significantly, the higher the fixed
operating costs, higher are the firms, operating leverage and its operating risks. High operating
leverage is good when revenues are rising and bad when they are falling.

Did u know? What is operating risk?
Operating risk is the risk of the firm not being able to cover is fixed operating costs.
The larger is their magnitude, the larger is the volume of sales required to cost all fixed costs.
The effects of changes in fixed operating expanses on operating leverage can be best explained
by continuing our example.

Example: Assume that A Company exchanges a portion of its variable operating costs
for fixed operating costs by eliminating sales commission and increasing sales salaries. This
change results in reduction of variable operating costs by 5% of sales and increase in fixed
operating costs from 50,000 to 60,000. At base level of 2000 units, there will be no change in
EBIT of 50,000 but operating leverage will change as shown below.
Case 2 – 50% Base data Case 1 + 5-%
Sales in units 1000 2000 3000
Sales revenue 100,000 200,000 300,000
Less variable operating costs 45,000 90,000 135,000
Contributions 55,000 110,000 165,000
Less fixed operating costs. 60,000 60,000 60,000
EBIT –5000 50,000 105,000
–110% +110%

Hence degree of operating leverage has become 

Task The following data is available for X Ltd.:
Selling price 120 pu; Variable cost 70 pu; Total fixed cost 200,000
1. What is the operating leverage when, X Ltd. produces and sells 6000 units,
2. What is the percentage change that will occur in the operating profit (EBIT) of X Ltd.,
if output increases by 5 per cent?

Self Assessment

Fill in the blanks:
5. ………………….. is used by the firm to determine the level of operations necessary to cost
all operating costs.
6. Changes in ………………….. costs affect operating leverage.
7. High operating leverage is good when ………….. are rising and bad when they are falling.

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