Fixed over a certain range of sales and increase to

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fixed over a certain range of sales and increase to higher levels for higher sales or production volume. The operating leverage may be defined as the firm’s ability to use fixed operating costs to magnify the effect of changes in sales on its earnings before interest and taxes. Operating leverage occurs any time the firm has fixed operating costs. In other words, operating leverage is the presence of fixed operating costs in the firm’s cost structure. Firms employee assets with fixed costs in the hope that sales volume will result in revenue more than sufficient to cover all fixed and variable costs. It is to imply that for a firm with fixed costs, the percentage change in profits as a result of a change in sales volume is greater than the percentage change in the volume of sale. It is this effect that you can call operating leverage. Furthermore, you can explain operating leverage as a measure of relationship between output or sales volume and EBIT. Specifically, it measures the effect of changing levels of output or sales volume on EBIT. The relationship can be depicted as: For illustrative purpose assume that GYB Trading sells merchandizing items for Br. 200 per unit. The variable cost per unit is Br.100. The firm’s annual fixed cost is Br. 100,000. It is EBIT = function (Quantity), with Components of operating leverage as: Sales Revenue (PQ) Less: Variable Operating Costs (VQ) Less: Fixed operating Costs (F) EBIT = Operating profits
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Financial Management I Acct 321 Arba Minch University Accounting and Finance Department 83 observed that the current level of sales volume is 4,000 units. Assume further that the firm’s sales volume (a) decreases to 3,000 units and (b) increases to 5,000 units. Show the various EBIT levels and observe the change in EBIT for the changes in volume of sale; take 4,000 units as base level of sales. EBIT for Various Levels of Sales (a) Base (b) -25% * +25%^ Sales in unit 3,000 4,000 5,000 Sales Revenue Br.60,000 Br.80,000 Br.100,000 Less Variable operating cost 30,000 40,000 50,000 Contribution margin Br.30,000 Br. 40,000 Br. 50,000 Less Fixed operating cost 30,000 30,000 30,000 EBIT (Operating profit) 0 Br.10,000 Br. 20,000 -100% # +100% @ *, ^, #,@The computation is done as follows: * Q a -Q base X100% = 3000-4000 X 100% = -25% Q base 4000 ^ Q b -Q base X100% = 5000-4000 X 100% = +25% Q base 4000 # EBIT a - EBIT base x 100% = 0- 10,000 X 100% = -100% EBIT base 10,000 @ EBIT b - EBIT base x 100% = 20,000- 10,000 X 100% = +100% EBIT base 10,000 From the above computations, you can observe that 1) In case (a), a 25 per cent decrease in sales volume (i.e., from 4,000 units to 3,000 units) results in a 100 per cent decrease in EBIT (i.e., from 10,000 to zero) 2) In case (b), a 25 per cent increase in sales volume (i.e., from 4,000 units to 5,000 units) results in a 100 per cent increase in EBIT (i.e., from Br.10,000 to Br.20,000) 3) The illustration clearly shows that when a firm has fixed operating costs, an increase in sales volume results in more than a proportionate increase in EBIT. Similarly, a decrease in the
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Financial management I Acct321 Arba Minch University Business and Economics Faculty 84 level of sales has the same but opposite effect. It is such effects that you can call operating leverage. The increasing effect is to be considered as favorable while the opposite is unfavorable for firms.
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