Operating Leverage

This text discusses the concept of operating leverage and how it can be used to measure the business risk of a company.

The text provides an example of how to calculate the degree of operating leverage for two different companies, and it discusses which company has the greater amount of business risk.

Questions

• What is operating leverage?
• How can the degree of operating leverage be calculated?
• Which company has the greater amount of business risk? Why?

Answers

• Operating leverage is a measure of how a company’s profits are affected by changes in sales. A company with high operating leverage will experience larger changes in profits for a given change in sales.
• The degree of operating leverage can be calculated by dividing the contribution margin by EBIT.
• Company A has the greater amount of business risk because it has higher operating leverage. This means that Company A’s profits are more sensitive to changes in sales.