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OPERATING LEVERAGE

Operating leverage results from the existence of fixed operating expenses in the firm’s income firm. The operating costs of a firm fall into three categories. (i) fixed costs which may be defined those which do not vary with sales volume, they are a function of time and are typically contractual; they must be paid regardless of the amount of revenues available; (ii) variable costs vary directly with the sales volume; and (iii) semi-variable or semi-fixed costs are those are partly fixed and partly variable. They are fixed over a certain range of sales volume and increase to higher levels for higher sales volumes. Since the last category of costs can be broken down into fixed and variable components, the costs of a firm, in operational terms, can he divided into (a) fixed, and (b) variable.

The operating leverage may be defined as the firm’s ability to use fixed operating costs to magnify the effects of changes in sales on its earnings before interest and taxes. Operating leverage occurs any time a firm has fixed costs that must be met regardless of volume. We employ assets with fixed cost in the hope that volume will produce revenues more than sufficient to cover all fixed and variable costs. In other worth, with fixed costs, the percentage change in profits accompanying a change in volume is greater than the percentage change in volume. This occurrence is known as operating leverage.

EBIT at Various Sales Levels

TABLE

OPERATING LEVERAGE

OPERATING LEVERAGE

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