Operating Leverage Flashcards
The CEO of Foley, Inc., a historically labor intensive business, has been meeting with operations management to discuss to possibility of investing in automated equipment in their factories. If this investment is made, the nature of production would change from a labor intensive business to a capital-intensive business. Current employees working in the factories would be reduced as a consequence of making this change. Fortunately, they can be placed in new jobs elsewhere in a factory that will be opening soon.
Mr. Foley would like you to explain to him what operating leverage is and the advantages and disadvantages involved with possibly changing the way business is done in terms of operating leverage.
Please send a message to Mr. Foley and the rest of top management defining the concept of operating leverage.
-Operating leverage is the degree to which fixed costs are used in proportion to variable costs in achieving income as reflected on the income statement.
-The degree of operating leverage risk increases with increases in fixed costs such as automation.
The CEO of Foley, Inc., a historically labor intensive business, has been meeting with operations management to discuss to possibility of investing in automated equipment in their factories. If this investment is made, the nature of production would change from a labor intensive business to a capital-intensive business. Current employees working in the factories would be reduced as a consequence of making this change. Fortunately, they can be placed in new jobs elsewhere in a factory that will be opening soon.
Mr. Foley would like you to explain to him what operating leverage is and the advantages and disadvantages involved with possibly changing the way business is done in terms of operating leverage.
Please send a message to Mr. Foley and the rest of top management explaining relevant considerations of how the current decision will be impacted and should be considered from the perspective of the risk/return tradeoff.
-The risk in this context is indicated by the difficulty in reaching the breakeven point.
-Labor intensive businesses reflect a cost structure comprised of significant variable costs and minimal fixed costs, while capital intensive businesses reflect significant fixed costs in comparison to variable costs.
-If the factory chooses to increase automation while decreasing direct labor, the structure of the income statement will reflect an increased risk of not breaking even.
-The tradeoff, in terms of the minimization of variable costs means that once the company has reached the breakeven point, they will be making more money on each unit sold.
-Management must consider whether the volume of forecasted sales will be adequate to meet and exceed the breakeven point and ultimately achieve an income that is higher than it would otherwise be under current conditions.
