20,000 40,000 60,000
degree of operating leverage
Percentage change in profit from a 1% change in output
does firm B. For example, at a production level of 40,000 units, B is losing $8,000, but A breaks even. Firm C is highly automated and has the highest fixed costs, but its variable costs rise slowly. Firm C has a higher breakeven point than either A or B, but once C passes the breakeven point, profits rise faster than those of the other two firms.
The degree of operating leverage is the percentage change in profit that results from a 1 percent change in units sold:
Degree of Operating Leverage =
Percentage Change in Profit Percentage Change in Sales An/n
The degree of operating leverage is an elasticity concept. It is the elasticity of profits with respect to output. When based on linear cost and revenue curves, this elasticity will vary. The degree of operating leverage is always greatest close to the breakeven point.
For firm B in Figure 8.13, the degree of operating leverage at 100,000 units of output is 2.0, calculated as follows:4
($41,600 - $40,000)/$40,000 (102,000 - 100,000)/100,000
Here, n is profit and Q is the quantity of output in units.
For linear revenue and cost relations, the degree of operating leverage can be calculated at any level of output. The change in output is AQ. Fixed costs are constant, so the change in profit An = AQ(P - AVC), where P is price per unit and AVC is average variable cost. Any initial profit level n = Q(P - AVC) - TFC, so the percentage change in profit is
The percentage change in output is AQ/ Q, so the ratio of the percentage change in profits to the percentage change in output, or profit elasticity, is
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