Operating leverage: The Basics

In simple words, operating leverage is convenient for a company to grow its revenue without an increase in its fixed cost

Asset heavy companies who have high fixed cost like, depreciation or rent, generally are eligible to have operating leverage

For these firms, if they want to grow their revenue, they will have to spend more at variable cost, but their fixed cost will remain the same

That means, it will lead to fast revenue growth compared to the growth of cost and will lead to fast profit growth compared to revenue growth

Let’s take a hypothetical example to understand operating leverage

Here, we have the company’s revenue, cost, and profit of 2 years

As we can see, the company’s revenue is increasing by 20 Rs – which is a 20% increase in revenue

With increasing revenue, the company also have a 10 Rs increase in variable cost, which is again 20% increase But company’s fixed cost is constant (company have an asset worth of 100 Rs by which it can produce its product, company doesn’t need another asset to increase its revenue, hence company’s fixed cost – which is depreciation – is constant)

Now, with no increase in fixed cost, the increase in total cost is now 14% only, and revenue is increasing by 20%

Hence proved, operating leverage leads to fast revenue growth compared to the growth of cost

Now, look at profit, profit is increased 33%, where revenue is increasing only by 20%

Operating leverage leads to fast profit growth compare to revenue growth

So, operating leverage is good, is correct

But operating leverage is not always good

Why?

Let’s take the same example, with the opposite scenario

Here, the company’s revenue is decreasing by 30%, and so variable cost is also decreasing by 30%

But But But, due to no decrease in fixed cost, the company’s total cost is decreasing by only 21%

Hence here, the company’s cost is decreasing by a lower rate than revenue

Have a look at profits, it is decreasing by 50%!

With a 30% decrease in revenue, profit is decreasing by 50%

Hence, operating leverage is not always good

Visit the advanced meaning and interpretation of operating leverage

https://aakashandmeet.wordpress.com/2020/07/25/operating-leverage-a-framework-for-anticipating-changes-in-earnings/

Published by Aakash and Meet

I am Aakash Raotole I am currently doing Bcom from Dr. Patel and Rb Patel commerce college I am currently studying at finnacle investment academy Recently done distance internship with windrose capital, Pune - for a period of 14 weeks I am Meet Bhatt Completed HSC in commerce Now studying finbridge program at finnacle investment academy and Bcom externals I had completed CFA institute's investment foundation course and distance internship with Windrose capital, Pune - for a period of 14 weeks

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