How operating leverage financially benefits the firm
Operating leverage entails the use of high fixed operating costs which essentially, as opposed to the use of high levels of variable operating costs which vary depending on the input such the volume used. The use of high fixed operating costs essentially implies that the firms would incur constant costs while it enjoys the variables costs to the maximum. This consequently leads the firm into achieving breakeven point later after the realization of more sales compared to users of lower operating leverage.
The advantage in the high operating leverage lies in the fact that upon the attainment of the breakeven point, an increase in the sales revenue causes a larger increase in the operating income. This is because the operating cost has been absorbed over a wider margin. It ought to be appreciated that the firm stands to benefit from the higher operating leverage after the attainment of the breakeven point and from thence onwards. Therefore, in order for a firm to benefit from operating leverage, it ought to first realize enormous sales that surpass the breakeven point. It would then utilize the high sales to capitalize on the operating income gained per incremental unit sold. The financial gains arise out of the collectiveness that comes about in bulk production. Operating expenses like rental costs, salaries to employees and insurance varies only from one time to another and does not strictly rely on the volumes produced and sold by the firm. It is these expenses that encompass the operating leverage.
How the firm calculates / determines its breakeven point
The breakeven point refers to the point where the firm makes no profit or loss. As such, breakeven refers to the point when the total revenues in the firm equal to the total costs incurred. The firm stands to neither loss nor gain at breakeven. It is after breaking even that the firm starts to make profits. The breakeven thus helps in decision making concerning the targeted profits. A firm that has target profit must first breakeven then pursue its target profit. Consequently, the firm must calculate its breakeven point. The breakeven point can be calculated through two methods, namely: the breakeven in units or the breakeven in revenues as illustrated below;
Assume S is the selling price per unit, b is the variable cost per unit, f is the fixed costs, and q is the quantities at breakeven point.
At the point of breakeven:
The total revenue (TR) = the total cost (TC)
The total revenue (TR) = sq (selling price per unit x quantities at breakeven point)
The total cost (TC) = bq + f (variable cost per unit x quantities at breakeven + the fixed costs)
At breakeven, therefore:
Sq = bq + f
Q = bq /s + f / s
Q = (bq + f) /s
Q = f/ (s-b)
Q = fixed costs / (selling price per unit p – variable costs per unit)
Example one: badges sold at nine dollars and costing five dollars to produce incurs a total of two thousand dollars in the rental costs at a trade fair. The breakeven point in terms of units will be;
Q = f / (s-b)
Q = fixed costs / (selling price per unit – variable price per unit)
2000 / (9-5) = 500 units.
Example two: the cost of renting a stall in a market is 200 dollars per day. A grocer deals in apples which he buys at 1 dollar and sells at two dollars each. His breakeven point will be;
Q = f / (s- b)
Q = 200 / (2-1) = 200 apples per day.
Brigham, E. F., & Ehrhardt, M. C. (2010). Financial Management Theory and Practice. New York: Cengage Learning.
Lasher, W. (2010). Practical Management Accounting. New York: Cengage Learning.