Given the risk of not absorbing the fixed operating costs throughout a lean phase, a firm with high operating leverage risks increases operational risk. If production or sales were non-existent, operating charges would not accrue. As a result, operating risk is nil, and the degree of operating leverage will be equals to one before taxes and interest. Alternatively, considering a company with fixed operational costs. The corporation would still need to pay for the fixed running costs, such as property taxes, rent, fixed wages, and so on, regardless of whether it generates income. Operational risk is the possibility that the business may not fulfill these fixed costs, resulting in operating losses. Various variables that might lead to lower-than-anticipated earnings or losses are considered when a company assesses its business risk. The benefits of operating leverage increase in good times as sales increase, but they are accentuated in difficult times, creating a substantial business risk. A company with low operating leverage has a small financial risk because it cannot absorb the fixed operating costs throughout a lean phase.
The contribution margin represents the total income available after variable costs to pay for fixed expenses and generate profit for the firm. In addition, contribution margin may help a firm determine how many units it needs to sell to cover its fixed costs, how to price its product correctly, and how to do a break-even analysis. As a bonus, it also explains how to compute operating leverage. According to the Operating Leverage Calculation, companies can enhance their net income by growing sales to a certain extent by increasing their operating leverage (Chen et al., 2019). When it comes to calculating operating leverage, the company divides the Contribution Margin by the profit.
Reference
Chen, Z., Harford, J., & Kamara, A. (2019). Operating leverage, profitability, and capital structure. Journal of financial and quantitative analysis, 54(1), 369-392. Doi:10.1017/s0022109018000595