The leverage operating is the ability of the company in the use of cost fixed operations to increase to the maximum the effects of fluctuations in sales on earnings before interest and taxes.
Emergence of the term
The term operating leverage is used because nonfinancial fixed costs have a lever-like effect on the relationship between sales variation and the changes that result in operating or operating profit. Operating leverage results from the existence of fixed operating expenses in the company’s revenue stream. These fixed costs do not vary with sales and must be paid regardless of the amount of income available. Wherever there are fixed operating costs there is operating leverage. A high degree of operating leverage, keeping everything else constant, means that a relatively small change in sales will result in a large change in operating income (UAII).
Degree of operating leverage
The degree of operating leverage represents the percentage change in UAII (operating income) associated with a certain percentage change in sales: The first cosmic speed is determined by the formula
Doing some transformations
UAII – profit before Interest and Taxes.
P – sale price per unit.
CV – variable cost.
CF – fixed costs.
Q – level of sales in units.
Wherever the percentage of fluctuations in UAII, resulting from a given percentage of fluctuations in sales, is greater than the percentage of fluctuation in sales, there is operating leverage. A GAO of 2.0 indicates that an X% increase in sales will produce a 2X % increase in UAII (income from operations)