Textbook Problem

Changes in sales cause changes in profits. Would the profit change associated with sales changes be larger or smaller if a firm increased its operating leverage? Explain your answer.

Summary Introduction

To explain: Whether the change in profit associated with change in sales be larger or smaller if a firm increases its operating leverage.

Introduction:

Operating Leverage:

Operating leverage refers to the use of both fixed as well as variable costs to make sales. Change in sales level leads to change in earnings before interest and tax.

Answer to Problem 1Q

Yes, change in profit associated with change in sales will be larger if a firm increases its operating leverage.

Explanation of Solution

• As change in sales leads to change in profits, it also increases the operating leverage.
• Sales and profits have positive relationship, but a small change in sales leads to more change in the profit.
• Higher fixed expenses leads to higher operating leverage.
• Increase in operating leverage represents the higher profits as the degree of operating leverage can be determined with the formula,

$\text{Degree}\text{of}\text{operating}\text{leverage}=\frac{\text{Percentage}\text{change}\text{in}\text{EBIT}}{\text{Percentage}\text{change}\text{in}\text{sales}}$

Where,

• EBIT is earning before interest and tax.

Conclusion

So, the change in profit would be larger if a firm increases its operating leverage.