Short Articles (PDF) - Excellence in Financial Management

What is Operating Leverage
The use of fixed assets in generating earnings is referred to as operating leverage.
Operating Leverage is measured by comparing the change in profits to the change in
sales. Higher levels of operating leverage tend to result in wider variations in profits
given a change in sales. This variation is called operating risks. Therefore, higher
levels of fixed costs are often associated with high levels of operating risks which in
turn leads to fluctuations of earnings given a change in sales.
Breakeven analysis is often used in conjunction with operating leverage. As we
increase sales beyond the breakeven point, the effects of operating leverage
diminish since the sales base we are using has increased. We can use breakeven
analysis to calculate operating leverage.
Degree of Operating Leverage (DOL) = % Change in EBIT / % Change in Sales
EXAMPLE: Price of Product = $ 10.00, Variable Cost per unit = $ 6.00, Fixed Costs =
$ 12,000 and 5,000 units are sold.
DOL = (($ 10.00 - $ 6.00) x 5,000) / ((($ 10.00 - $ 6.00) x 5,000) - $ 12,000) = 2.5
What we can conclude from our calculation is that when sales increase by say 10%,
we can expect a 25% increase in earnings since we have operating leverage of 2.5.
Thus, operating leverage gives us some measure of variations in earnings from
changes to sales.
What is Zero Working Capital
Working capital is the comparison of current assets to current liabilities. For most
organizations, current assets exceed current liabilities and working capital therefore
represents the liquid reserves for meeting current obligations. Creditors prefer high
levels of working capital since they are concerned about receiving payment.
However, management prefers low levels of working capital since working capital
earns an extremely low rate of return. Some companies are now driving working
capital to record low levels, so-called Zero Working Capital. By keeping working
capital at zero, funds are released for many other opportunities.
Zero Working Capital requires major changes in how an organization functions. One
way to implement Zero Working Capital is to have a demand-based organization.
Demand-based organizations do everything only as they are demanded: Fill
customer orders, receive supplies, manufacture products, and other functions are
done only as needed. The production facilities run 24 hours a day non-stop according
to the demands within the marketplace. There are no inventories; everything is
supplied immediately as needed. The end result of this demand driven organization
is that little, if any, working capital is necessary to run the business.
8