Chapter 10 Operating Leverage

Chapter 10 Operating Leverage - 4/19/2011 Chapter 10...

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Chapter 10 Operating Leverage Operating leverage measures how sensitive, or how risky a company's profit is to a changes in sales. For example, assume Bill's Tie Company has a 10 percent increase in sales, and its profit increases 12%. Bill's Tie Company is not very sensitive to the change as seen in the very small difference in the changes in profit compared to sales---10% compared to 12%. Suppose instead that Bill's 10 percent increase in sales generated a 40% increase in profit. Bill's Tie Company has a much more sensitive the change in sales, and therefore considered to be more risky as it relates to operations. Cost Structure To determine a company's operating leverage, we examine its cost structure. Cost structure refers to the amount of fixed costs incurred by a company in relation to the amount of variable costs it incurs. Companies with large costs tied up in production machines and equipment will often have relatively small amounts of assembly labor costs. Companies such as this have high depreciation costs, considered fixed costs, and lower variable costs since assembly labor is considered variable. Because it is difficult to eliminate most fixed costs in the short run, these companies have higher operating leverage and are considered to have more risky operations. Companies with a cost structure consisting of significant amounts of labor and fewer machines that aid in production will have lower fixed costs and higher variable costs. Variable costs are easier to reduce on a short term basis which makes these companies have lower operating leverage and are considered to
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This note was uploaded on 04/20/2011 for the course ACC 101 taught by Professor Xyz during the Spring '11 term at Ohio State.

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Chapter 10 Operating Leverage - 4/19/2011 Chapter 10...

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