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What is a company's operating leverage and how does it effect its profitability?

Question:

What is a company's operating leverage and how does it effect its profitability?

Managerial Accounting

Managerial accounting refers to the accounting framework that helps in the preparation and presentation of accounting information that is used by internal users such as managers to make decisions. Cost accounting is considered part of managerial accounting. Managerial accounting has the purpose of ensuring that company operations are profitable.

Answer and Explanation:

An organization's operating leverage refers to how the fixed costs of the organization relate to its variables costs. When a given organization has a high degree of operating leverage, it implies that it has a big fraction of fixed costs as compared to total costs. On the other hand, if an organization has a low degree of operating leverage, it means that it has a big fraction of variable costs to total costs.

Operating leverage is very important as it helps business to comprehend the effect of costs on an organization's profits. Therefore, organizations with a high degree of operating leverage need to ensure that a high number of sales is generated. This would cover the fixed costs. It should be noted that as the numbers of sales increase, a company's profitability also increase. A company with a low degree of operating leverage will not increase in profitability as the number of sales increase. This is for the reason that as sales increase, the variable costs also increase.


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Managerial Accounting Functions

from Business Management: Help & Review

Chapter 9 / Lesson 1
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