Question

Explain why operating leverage decreases as a company increases sales and shifts away from the break-even point.

Short answer

When the company increases the sales above the break even point, the percentage change in operating income as a result of percentage change in unit volume diminishes. It is so because upto the break even point, company is recovering the fixed cost but when the sale is above breakeven, the fixed cost is not charged and the EBIT of the company increase. Hence, when we move to increasingly higher level of operating income, the percentage change from the higher base is likely to be less.

Step-by-step solution

Step-by-Step Solution:Step 1: Break-even point

Break even point is the point at which the total cost (fixed and variable) and the total revenue of the company are equal. It is the point at which the fixed cost of the company is fully recognized.

Relationship between the operating leverage and the sales above break even point

When the sales of the company are above the break even point, then the operating leverage decreases. Operating leverage is computed by dividing the contribution with the earning before interest and taxes. After the break even point when the fixed cost is completely recognized, the EBIT of the company increases at high rate due to which the operating leverage of the company decreases.