Operating leverage effect

Question

Briefly explain the operating leverage effect and the reason for it to occur?  What are the advantages and limitations of high operating leverage?

Answer 1

Operating leverage effect is a phenomenon where a small variation in sales triggers a relatively large variation in operating income.  It is due to the presence of fixed operating costs.  The advantages of high operating leverage are that if sales are increasing operating income will go up more quickly.  The ill-effects are that declining sales will result in operating income to drop more quickly, including negative values.