Tuesday, July 1, 2014

Definition of 'Operating Leverage'

A measurement of the degree to which a firm or project incurs a combination of variable &  fixed costs.

1. A business that makes few sales, with each sale providing a very high gross margin, is said to be highly leveraged. A business that makes large sales, with each sale contributing a very low margin, is said to be less leveraged. As the quantum & volume of sales in a business increases, each new sale contributes to profitability.

2. A business, that has a higher proportion of fixed costs(FC)  & a lower proportion of variable costs is said to have used more operating leverage. Those businesses with lower fixed costs & higher variable costs are said to employ less operating leverage.

Expertsmind.com explains 'Operating Leverage'
If  the degree of operating leverage is high, then the potential danger from forecasting risk will be greater. If a relatively small error is made in forecasting sales, it can be magnified into large errors in cash flow projections. If there is less leveraged that is true for businesses. A business that sells many thousands of products a year, with each contributing slightly to paying for fixed costs, is not as dependent on each individual sale.

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