Answer & Solution
Answer: Option
A
Solution:
Operating Leverage (OL) is a measure of how a change in sales will affect operating income (EBIT). It exists because of the presence of fixed operating costs, which do not change with the level of production or sales.
The formula for Operating Leverage is:
OL = Contribution / EBIT
Contribution is calculated as Sales minus Variable Costs. If a firm has fixed operating costs, then EBIT will be lower than Contribution, making OL greater than 1.
However, if fixed cost of production is zero, it means all costs are variable. There is no cost that remains constant regardless of the production level.
In such a case, Contribution equals EBIT, and there's no leverage effect. This means there is no magnifying impact of sales changes on EBIT.
When there is no fixed cost, Operating Leverage becomes zero or negligible, as there is no risk or benefit from sales fluctuations—every additional unit sold adds directly to profit without covering any fixed cost.
Financial Leverage (FL) is not related to production costs. It arises from interest on debt or other fixed financial obligations, which are not mentioned in the question.
Combined Leverage (CL) is the combination of both OL and FL. If OL is zero but FL is not, then CL is not zero. So we cannot say CL is zero unless both OL and FL are zero.
Therefore, based on the absence of fixed production costs, the correct interpretation is that Operating Leverage is zero.
Hence, the correct answer is Option A: OL is zero.
