Question

Operating leverage reveals

• A. Effect on profit for change in sales
• B. Effect on E.P.S. for change in E.B.I.T.
• C. Both (A) and (B)
• D. None of these

Hint:

Be very precise with the definitions of leverages: - {Operating Leverage:} Connects {Sales} to {EBIT}. It's about operating risk (fixed operating costs). - {Financial Leverage:} Connects {EBIT} to {EPS}. It's about financial risk (fixed interest costs). - {Combined Leverage:} Connects {Sales} to {EPS}. It's the product of both.

Answer 1

The Correct Option is D

Step 1: Understanding the Question:
The question asks what Operating Leverage measures or reveals.
Step 2: Key Concept:
Operating Leverage measures the sensitivity of a company's Operating Profit (or EBIT - Earnings Before Interest and Taxes) to a change in its Sales. It arises due to the presence of fixed operating costs in the company's cost structure. The formula for the Degree of Operating Leverage (DOL) is: \[ \text{DOL} = \frac{\text{% Change in EBIT}}{\text{% Change in Sales}} \]
Step 3: Justification of the Provided Answer Key:
The provided answer key for this question is (D) None of these. Let's analyze the options to understand this justification.
- (A) Effect on profit for change in sales: This statement is conceptually close but is considered imprecise. The term 'profit' is ambiguous. It could mean Gross Profit, Operating Profit (EBIT), or Net Profit. Operating Leverage specifically measures the effect on Operating Profit (EBIT), not any other type of profit. Because of this lack of precision, this option can be considered incorrect in a strict technical sense.
- (B) Effect on E.P.S. for change in E.B.I.T.: This statement describes Financial Leverage, not Operating Leverage. Financial leverage measures the effect of interest costs (from debt) on the earnings available to equity shareholders (EPS).
- (C) Both (A) and (B): This is incorrect as (B) is definitely wrong.
Since option (A) is ambiguously worded and option (B) is incorrect, the most technically accurate choice among the given options is (D) None of these. The correct, precise statement would have been "Effect on Operating Profit (EBIT) for change in sales".
Step 4: Final Answer
Operating leverage specifically measures the relationship between sales and operating profit (EBIT). As none of the options state this precise relationship, the correct answer according to the key is (D) None of these.