Operational leverage Keywords, Formulas and Questions Flashcards
What is operating leverage
A measure of the sensitivity of profits to changes in sales
The greater the proportion of fixed costs to variable costs…
The greater the leverage
The greater the degree of operating leverage…
The more any changes in sales activity will change profit
If a company has a higher fixed costs compared to their variable costs what is their degree of operating leverage?
Higher
What happens to an entity’s profits compared to their sales changes if the operating leverage is higher?
The profits are more sensitive to any changes
In periods of positive growth is having a high operating leverage good/bad? why?
Good because fixed costs don’t increase with increases in activity
In periods of negative growth is having a high operating leverage good/bad? why?
Bad because the fixed costs don’t decrease with the decreases in activity
What does having a high fixed cost structure compared to a low variable structure do to a business? why?
Keeps the business at more risks as the breakeven point goes up resulting in having to have a large volume of sales in order to have a positive margin of safety
What is relevant costing periods useful for and what does this include?
BINARY decisions:
- Invest/don’t invest
- Continue/discontinue
- Accept/reject
What are opportunity costs?
The value of the opportunity forgone in order to pursue the course of action implicit within the decision
What is the formula for the degree of operational leverage?
Total contribution/ Net profit
What is a sunk cost?
An investment already incurred that cannot be recovered
