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    Causes of a High Degree of Operating Leverage

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    What conditions/factors cause a business to have a high degree of operating leverage as compared to others?

    It is a good idea to understand the percentage of margin we are creating. In this way, we can keep an eye on the amount of revenue, cost and gross profit; and compare these to prior periods so we can review the trends and use the information to make decisions. What other information can this tell us?

    It is good to purchase a large quantity of widgets, or will you possibly get stuck in the end with a warehouse full of unsellable widgets?

    This is also the idea of covering your costs. The margin itself is how much "profit" or gross profit we make "per unit sold". That is, the sales value less the cost of making that particular item. The cost to manufacture will be the materials and labor. The remainder will be profit to be used to pay our other general expenses. What else can we use this information for? If the margin is not positive, or large enough, what steps can we take to correct this?

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    Solution Preview

    - What conditions/factors cause a business to have a high degree of operating leverage as compared to others?

    The businesses that have the most sales and that are able to expand their markets have the lowest degrees of operating leverage. In a business that has high operating leverage, the fluctuations in sales affect the company's profit more than a company with high or continual sales. As sales grow, the cost of production increases because the increased volume decreases the degree that the fixed costs affect profitability. If I sell 100 products per year and my fixed costs are $50,000, my per unit cost to fixed costs is 50,000 / 100 = $500. However, if my sales increase and I sell 35,000 products the following year, my cost structure has now changed to 50,000 / 35,000 = $1.43 per unit to ...

    Solution Summary

    This solution explains the causes of a high degree of operating leverage. The conditions and factors that cause this are discussed. I also discuss if it is good to purchase a large quantity of products or if the excess purchases could turn into obsolete inventory and high carrying costs in the meantime.