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Operating Leverage

Operating leverage is a measure of how much a company's operating income will change with a change in revenue. It is calculated as the contribution margin divided by profit. Companies with high fixed costs and low variable costs have high operating leverage, while those with low fixed costs and high variable costs have low operating leverage. Examining a company's operating leverage can provide insights into its break-even point and how effectively it uses fixed assets to generate profits.

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187 views3 pages

Operating Leverage

Operating leverage is a measure of how much a company's operating income will change with a change in revenue. It is calculated as the contribution margin divided by profit. Companies with high fixed costs and low variable costs have high operating leverage, while those with low fixed costs and high variable costs have low operating leverage. Examining a company's operating leverage can provide insights into its break-even point and how effectively it uses fixed assets to generate profits.

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Niño Rey Lopez
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© © All Rights Reserved
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Operating Leverage

What Is Operating Leverage?


Operating leverage is a cost-accounting formula that measures the degree to
which a firm or project can increase operating income by increasing revenue. A
business that generates sales with a high gross margin and low variable costs
has high operating leverage.

KEY TAKEAWAYS

 Operating leverage is used to calculate a company’s break-even point and


help set appropriate selling prices to cover all costs and generate a profit.
 Companies with high operating leverage must cover a larger amount of
fixed costs each month regardless of whether they sell any units of
product.
 Low-operating-leverage companies may have high costs that vary directly
with their sales but have lower fixed costs to cover each month.
Understanding Operating Leverage
The higher the degree of operating leverage, the greater the potential danger
from forecasting risk, in which a relatively small error in forecasting sales can be
magnified into large errors in cash flow projections.

The Operating Leverage Formula Is:


\text{Degree of operating leverage} = \frac{\text{Contribution margin}}{\
text{Profit}}Degree of operating leverage=ProfitContribution margin
This can be restated as: 

\begin{aligned} &\text{Degree of operating leverage} = \frac{Q*CM}


{Q*CM - \text{Fixed operating costs}}\\ &\textbf{where:}\\ &Q = \
text{unit quantity}\\ &CM = \text{contribution margin (price - variable
cost per unit)}\\ \end{aligned}
Degree of operating leverage=Q∗CM−Fixed operating costsQ∗CM
where:Q=unit quantityCM=contribution margin (price - variable cost per u
nit)
The operating leverage formula is used to calculate a company’s break-even
point and help set appropriate selling prices to cover all costs and generate a
profit. The formula can reveal how well a company is using its fixed-cost items,
such as its warehouse and machinery and equipment, to generate profits. The
more profit a company can squeeze out of the same amount of fixed assets, the
higher its operating leverage.

One conclusion companies can learn from examining operating leverage is that
firms that minimize fixed costs can increase their profits without making any
changes to the selling price, contribution margin, or the number of units they sell.

Example
For example, Company A sells 500,000 products for a unit price of $6 each. The
company’s fixed costs are $800,000. It costs $0.05 in variable costs per unit to
make each product.

Calculate company A’s degree of operating leverage as follows:

500,000∗($6.00−$0.05)−$800,000500,000∗($6.00−$0.05)
=$2,175,000$2,975,000=1.37 or 137%.
A 10% revenue increase should result in a 13.7% increase in operating income
(10% x 1.37 = 13.7%).

High and Low Operating Leverage


It is important to compare operating leverage between companies in the same
industry, as some industries have higher fixed costs than others. The concept of
a high or low ratio is then more clearly defined.

Most of a company’s costs are fixed costs that recur each month, such as rent,
regardless of sales volume. As long as a business earns a substantial profit on
each sale and sustains adequate sales volume, fixed costs are covered and
profits are earned.

Other company costs are variable costs that are only incurred when sales occur.
This includes labor to assemble products and the cost of raw materials used to
make products. Some companies earn less profit on each sale but can have a
lower sales volume and still generate enough to cover fixed costs.

For example, a software business has greater fixed costs in developers’ salaries
and lower variable costs in software sales. As such, the business has high
operating leverage. In contrast, a computer consulting firm charges its clients
hourly and doesn't need expensive office space because its consultants work in
clients' offices. This results in variable consultant wages and low fixed operating
costs. The business thus has low operating leverage.
Most of Microsoft’s costs are fixed, such as expenses for upfront development
and marketing. With each dollar in sales earned beyond the break-even point,
the company makes a profit, but Microsoft has high operating leverage.

Conversely, Walmart retail stores have low fixed costs and large variable costs,
especially for merchandise. Because Walmart sells a huge volume of items and
pays upfront for each unit it sells, its cost of goods sold increases as sales
increase. Because of this, Walmart stores have low operating leverage.

What Does Operating Leverage Tell You?


The operating leverage formula is used to calculate a company’s break-even
point and help set appropriate selling prices to cover all costs and generate a
profit. This can reveal how well a company is using its fixed-cost items, such as
its warehouse and machinery and equipment, to generate profits. The more profit
a company can squeeze out of the same amount of fixed assets, the higher its
operating leverage.

One conclusion companies can learn from examining operating leverage is that
firms that minimize fixed costs can increase their profits without making any
changes to the selling price, contribution margin, or the number of units they sell.

What Is the Degree of Operating Leverage (DOL)?


The degree of operating leverage (DOL) is a multiple that measures how much
the operating income of a company will change in response to a change in sales.
Companies with a large proportion of fixed costs (or costs that don't change with
production) to variable costs (costs that change with production volume) have
higher levels of operating leverage. The DOL ratio assists analysts in determining
the impact of any change in sales on company earnings or profit.

What Are Examples of High and Low Operating Leverage?


Companies with high fixed costs tend to have high operating leverage, such as
those with a great deal of research & development and marketing. With each
dollar in sales earned beyond the break-even point, the company makes a profit.
Conversely, retail stores tend to have low fixed costs and large variable costs,
especially for merchandise. Because retailers sell a large volume of items and
pay upfront for each unit sold, COGS increases as sales increase. Because of
this, such stores often have low operating leverage.

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