The Basic Idea

Operating leverage is the degree to which a project or firm is committed to fixed production costs. A firm with low operating leverage will have low fixed costs compared to a firm with high operating leverage. Generally speaking, projects with a relatively heavy investment in plant and equipment will have a relatively high degree of operating leverage. Such projects are said to be capital intensive.

Anytime we are thinking about a new venture, there will normally be alternative ways of producing and delivering the product. For example, Wettway Corporation can purchase the necessary equipment and build all of the components for its sailboats in-house. Alternatively, some of the work could be farmed out to other firms. The first option involves a greater investment in plant and equipment, greater fixed costs and depreciation, and, as a result, a higher degree of operating leverage.

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