Welcome to professrsavings.com, we teach finance basics.
Today we will teach you operating leverage in two minutes.
Operating leverage is the relationship between a company’s fixed and variable costs.
The airline industry tends to have high operating leverage.
The fixed costs for Highfly airlines include leases for its aircraft, salaries of its crew paid annually, aviation insurance, hanger rental.
Its variable costs, these are cost that would change, are refreshments for passengers and airplane fuel. HiFly’s fixed costs are higher than its variable costs.
Therefore the company has a high operating leverage.
A company with a high operating leverage like Highfly h will see its profits go up when its ticket sales increase because fixed cost remain the same.
But remember, a company with low operating leverage in a declining sales period must still pay its fixed cost and it will thus suffer bigger losses.
Let’s jump to an example.
The degree of operating leverage DOL of a firm measures how well a company generates profit using its fixed cost.
It is calculated as sales minus variable costs divided by profit.
If HiFly earns ticket sales of $4,000)and has variable costs of $500 and fixed costs of $$1200 then its profit is $4000 minus $500minus $1200equals $$2300
Its DOL is $4,000 minus $500 divided by$3,300 equals =1.2
HiFly’s competitor Mr.Bus also earns bus seat sales of $4000 Its variable and fixed costs are $1000 and $500)respectively.
For a profit of $4000 minus $1000 minus $500 equals $12,500
Mr.Bus DOL is $4000 minus $1000 divided by $2500 equals 1.2. (.6)
HiFly’s operating leverage is higher than Mr.Bus given their DOL.
This example shows how operating leverage magnifies both profits and losses.