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Unit 8: Concept of Leverages
Notes
Percentage change in EBIT
Hence, Operating leverage =
Percentage change in sales
+ 100% – 100%
= = 2 (case I), = 2 (case II).
+ 50% – 50%
Self Assessment
Fill in the blanks:
1. Operating leverage results from the existence of the fixed operating expenses in the firm’s
………….stream.
2. ………….costs are those which do not vary with sales volume.
3. …………………costs are those, which are partly fixed and partly variable.
4. ………………..costs are the costs which vary directly.
8.2 Relation with Break-even Analysis
Break-even analysis is used by the firm.
1. To determine the level of operations necessary to cost all operating costs and,
2. To evaluate the profitability associated with various levels of sales. The firms operating
break-even point are the level of sale necessary to give all operating costs. At that point,
earnings before interest and taxes equal zero.
In the example, we see that the firm has reached breakeven (‘0’ profit) at the sales level of 1000
units, at which all the fixed and variable operating costs are coursed.
Did u know? Break-even analysis as is sometimes called cost volume profit analysis.
8.2.1 Changing Costs and the Operating Break-even Point
The firm’s operating breakeven point is sensitive to a number of variables. Fixed operating cost,
the sales price per unit and the variable cost per unit. The effects of increase or decrease in these
variables can be analyzed as under:
Increase in variable Effect on operating break-even
Fixed operating costs Increase
Sales price per unit Decrease
Variable operating cost per unit Increase
8.2.2 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.
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