Operating Leverage
What Does Operating Leverage Mean?
A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. (1) A business thathas limited sales, with each sale providing a very high gross margin, is said to be highly leveraged. A business that makesmany sales, with each sale contributing a very low margin, is said to be less leveraged. As the volume of sales in a businessincreases, each new sale contributes less to fixed costs and more to profitability. (2) A business that has a higher proportion offixed costs and a lower proportion of variable costs is said to use more operating leverage. Conversely, businesses with lowerfixed costs and higher variable costs are said to employ less operating leverage.
Investopedia explains Operating Leverage
The higher the degree of operating leverage, the greater the potential danger for inaccurately forecasting risk. That is, if arelatively small error is made in forecasting sales, it can be magnified into large errors in projections of cash flow. The oppositeis true for businesses that are less leveraged. A business that sells millions of products a year, with each contributing slightlyto paying for fixed costs, is not as dependent on each individual sale. For example, convenience stores are significantly lessleveraged than are high-end car dealershipsoperating leverage
The extent to which fixed operating costs magnify changes in sales or revenues into even greater proportionate changesin operating income. For example, a company that substitutes robots or other machinery for laborers also substitutesfixed costs for variable costs and increases its operating leverage. High operating leverage tends to produce volatileearnings. Compare financial leverag
Operating Leverage
The level to which a company is dependent on sales of individual products. That is, a company with only a few saleshas a high operating leverage because it must use these few sales to pay its operating expenses. On the other hand, acompany with many sales has a low operating leverage and may therefore sell more or fewer products without itaffecting its profitability as much
Why it Matters:
In a sense, operating leverage is a means to calculating a company's breakeven point. However, it's also clear from the formula that companies with high operating leverage ratios can essentially make more money from incremental revenues than other companies, because they don't have to increase costs proportionately to make those sales. Accordingly, companies with high operating leverage ratios are poised to reap more benefits from good marketing, economic pickups, or other conditions that tend to boost sales.
Likewise, however, companies with high operating leverage are more vulnerable to declines inrevenue, whether caused by macroeconomic events, poor decision-making, etc.
It is important to note that some industries require higher fixed costs than others. This is why comparing operating leverage is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.
Operating leverage is the ratio of a company's fixed costs to its variable costs.
How it works/Example:
Here is the formula for operating leverage:
Operating Leverage = [Quantity x (Price - Variable Cost per Unit)] / Quantity x (Price - Variable Cost per Unit) - Fixed Operating Cost
To see how operating leverage works, let's assume Company XYZ sold 1,000,000 widgets for $12 each. It has $10,000,000 of fixed costs (equipment, salaried personnel, etc.). It only costs $0.10 per unit to make each widget.
Using this information and the formula above, we can calculate that Company XYZ's operating leverage is:
Operating Leverage = [1,000,000 x ($12 - $0.10)] / 1,000,000 x ($12 - $0.10) - $10,000,000 = $11,900,000/$1,900,000 = 6.26 or 626%
This means that a 10% increase in revenues should yield a 62.6% increase in operating income (10% * 6.26).