Operating leverage results when fluctuations in sales revenue produce a wide fluctuation in operating profits. Operating leverage occurs where a firm has fixed cost of that must be met regardless of volume or value of sales. With fixed cost, the percentage change in operating profit accompanying a change in sales. This occurrence is known as operating leverage The degree of operating leverage depends upon the amount of fixed elements in the cost structure, Operating leverage in a firm is a function of three factors the rupee amount of fixed cost, the variable contribution margin, and the volume of sales. There are two approaches or calculating operating leverage can be measure at any level of output Q as :
L = Q (P-V)/ Q (P-V)-F
Where, Q is number of units sold,
P is selling price per unit.
V is the variable cost per unit.
F is the fixed cost. And
L is the degree degree of operating leverage
By the second approach operating leverage can be determined in terms of total rupee sales by means of break-even or cost volume profit analysis. The break-even analysis shows the degree of a firm’s operating leverage which at any level of sales is :
S – VC/S – VC-V or Contribution/Operation Profit
Where contribution = Sales – Variable Cost
and Operating leverage can be defined more precisely in terms of the way a given change in volume or value of sales affects profits. The degree of operating leverage is defined as the percentage change in operating income that result from a percentage change in units sold.