Changes in sales cause changes in profits. Would the profit change associated wi

Question

Changes in sales cause changes in profits. Would the profit change associated with sales changes be larger or smaller if a firm increased its operating leverages? Explain your answer. A firm is about to double its assets to serve its rapidly growing market. It must choose between a highly automated production process and a less automated one. It also must choose a capital structure for financing the expansion. Should the asset investment and financing decisions be jointly determined, or should each decision be made separately? How would these decisions affect one another? How could the leverage concept be used to help management analyze the situation?

Explanation / Answer

Degree Of Opearating Leverage = % Change in EBIT / % Change in Sales

If the Operating Leverage is increased, it implies that the Profit change associated with the sales changes are ,larger. We can see this from the above formula.

If the assets of the company are doubled, highly automated production process should be choosen.

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