The operating leverage is the degree to which a company or project can increase its operating income to the increase profits. A company that generates sales with a high gross margin and low variable costs has high operating leverage.
The greater the degree of operating leverage, the greater the potential hazard of the risk forecast, where a relatively small error in the sales forecast can be expanded to large errors in the cash flow projections.
Operating leverage can be used to calculate the breakeven point for a company and substantially affect earnings by changing its pricing structure.
Because companies with higher operating leverage do not proportionally increase expenses as sales increase, those companies can generate more operating income than other companies.
However, companies with a high level of operating leverage are also more affected by poor corporate decisions and other factors that can lead to lower revenues.
Operating leverage is an indicator of the combination of fixed costs and variable costs in a company’s cost structure.
High and low operating leverage
It is key to compare operating leverage between companies in the same industry. This is because some industries have higher fixed costs than others.
A company with high fixed costs and low variable costs has high operating leverage. On the other hand, a company with low fixed costs and high variable costs has low operating leverage.
A company with high operating leverage relies more on sales volume for profitability. The company must generate a high volume of sales to cover the high fixed costs. In other words, as sales increase, the company becomes more profitable.
In a company with a cost structure that has low operating leverage, increasing sales volume will not dramatically improve profitability, as variable costs increase proportionally with sales volume.
Fixed and variable costs
Most of a company’s costs are fixed costs, which occur regardless of sales volume.
As long as a business makes a substantial profit on each sale and maintains adequate sales volume, fixed costs will be covered and profits will be made.
Other company costs are the variable costs incurred when sales occur. The business makes less profit for each sale, but needs less sales volume to cover fixed costs.
Degree of operating leverage
The formula for the degree of operating leverage is:
Degree of operating leverage =
% change in net operating profit /% change in sales =
Contribution margin / Net operating profit.
This formula breaks down as follows:
Contribution margin = Quantity x (Variable Price-Cost per unit)
Net operating profit =
[Quantity x (Price-Variable cost per unit) -Fixed operating cost]
Advantages and disadvantages
Operating leverage can tell managers, investors, creditors, and analysts how risky a company can be.
Although a high degree of operating leverage can be beneficial to the business, companies with a high degree of operating leverage can often be vulnerable to the business cycle and changing macroeconomic conditions.
When the economy is booming, a high degree of operating leverage can increase a company’s profitability.
However, companies that need to spend a large amount of money on property, plant and machinery cannot easily control consumer demand.
So in the event of an economic downturn, your profits can plummet due to your high fixed costs and low sales.
Companies with high operating leverage are more vulnerable to declining revenues, whether due to macroeconomic events, poor decision making, etc.
Comparisons and check
Some industries require higher fixed costs than others. This is the reason why the comparison of operating leverage is more significant between companies within the same industry. The definition of a high or low grade must be done within this context.
When using the operating leverage indicator, its constant check on a company with high operating leverage is more important, as a small percentage change in sales can lead to a dramatic increase or decrease in profit.
A company must take special care when forecasting its revenue in these situations, as a small forecast error translates into much larger errors in both net income and cash flows.
A company with high operating leverage must be careful not to set prices so low that it can never generate enough contribution margin to fully cover its fixed costs.
Operating leverage is directly related to a company’s breakeven point. A company with a high breakeven point has a high level of operating leverage.
The breakeven point refers to the level of sales volume where the profit per unit fully covers the fixed costs of production. In other words, it is the point at which income equals costs.
Because high fixed costs translate into a higher breakeven point, higher sales volume is required to cover fixed costs. A production process with a high breakeven point uses high operating leverage.
Company A sells 500,000 products annually for $ 6 each. The fixed costs of the company are $ 800,000. Each product costs $ 0.05 in variable cost per unit to make. The degree of operating leverage for Company A is:
500,000 x ($ 6- $ 0.05) / [500,000 x ($ 6- $ 0.05) – $ 800,000] = $ 2,975,000 / $ 2,175,000 = 1.37 or 137%.
Therefore, a 10% increase in revenue should result in a 13.7% increase in operating income (10% x 1.37 = 13.7%).
Most of Microsoft’s costs are fixed, such as initial development and marketing expenses. With every dollar in sales revenue earned beyond breakeven, the business makes a profit. Therefore, Microsoft has a high level of operating leverage.
In contrast, Walmart retail stores have low fixed costs and large variable costs, especially for merchandise.
Because Walmart stores pay for the items it sells, the cost of merchandise sold increases as sales increase. Therefore, Walmart stores have a low level of operating leverage.
- Investopedia (2018). Operating Leverage. Taken from: investopedia.com.
- Wikipedia, the free encyclopedia (2018). Operating leverage. Taken from: en.wikipedia.org.
- Steven Bragg (2017). Operating leverage. Accounting Tools. Taken from: accountingtools.com.
- James Wilkinson (2013). Operating leverage. The Strategic CFO. Taken from: strategiccfo.com.
- Investing Answers (2018). Operating Leverage. Taken from: investinganswers.com.