70 Strategic Financial Management

(ii) Operating Leverage and Financial Leverage

The operating leverage indicates the overall operating performance of a corporation with a special
emphasis on its 'committed cost or fixed cost.' Financial leverage broadly explains the impact of 'cost
of borrowing,' i.e., financial cost or interest cost. Let us compute both the leverages:
' $
Million
Particulars
Sales 1,000
Less: Variable operating costs 600
Contribution 400
Less: Operating fixed cost 100

Operating profit (PBIT) 300

Less: Interest 60

Profit before tax (PBT) 240

. Less: Tax 70

Profit after tax (PAT) 170

Less: Dividend 100

Retained profit 70

1. Operating leverage = Contribution/Operating profit = 400/300

=1.33
2. Financial leverage = Operating profit/Profit before tax = 300/240

=1.25
Let us examine these two leverages:
Operating leverage shall always be more than 'one,' as operating fixed cost shall never be zero. A
corporation must attempt to reduce its operating leverage and bring it close to one: This should be
possible through three ways:
1. Contribution should increase by increasing sales and decreasing variable cost.
2. The operational fixed cost should be reduced with innovative and operational
efforts.
3. Maximum possible portion of the operating fixed cost should be converted into
operating variable cost, e.g., fixed cost of wages may be replaced by variable wages, i.e.,
permanent workers may be replaced by contract labourers who can be paid volume-based
wages (variable wages). Once the fixed or committed wages become variable, they become
discretionary for the corporation. During recession or transition, it can be reduced by
reducing the volume of production. Another example of conversion of fixed cost into variable
cost is of depreciation of buildings and premises into variable rent of buildings and the premises
to be used for inventory storage.