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What is Operating Leverage?
What’s important to know about it?
In this article, I will break down the meaning of Operating Leverage so you know all there is to know about it!
Keep reading as we have gathered exactly the information that you need!
Let me explain to you what Operating Leverage is all about and why it’s important!
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What Is Operating Leverage
In business and cost accounting, operating leverage is a measure of how much a company’s growth in revenue will translate into a growth in operating income.
In other words, operating leverage allows you to measure how much you can increase your operating income by increasing revenues.
For example, a company with low operating leverage will have low fixed costs to assume regardless of how many units it sells but will have increasing variable costs when selling more units.
On the other hand, a company with high operating leverage has the burden to assume higher fixed costs regardless of how many units it sells.
In essence, when you calculate your operating leverage, you are looking to see what is your break-even point for the sale of a particular product or service which allows you to set your price in such a way that you can generate profits.
Keep reading as I will further explain to you the meaning of operating leverage and tell you how it works.
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Why Is Operating Leverage Important
It’s important for companies to regularly measure their operating leverage to ensure that they are not exposing themselves to unwanted risk.
Particularly, companies with high operating leverage must generate enough cash to pay for their high level of fixed costs.
As a result, such companies should have a good understanding of how their profits can vary with variations in sales.
In some cases, a small change in revenues can lead to a significant change in profitability.
If a company is operating with lower profit margins and has an operating leverage that is sensitive to revenues, it must make sure that its sales forecasts are accurate to avoid operating losses.
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Operating Leverage Formula
To calculate your operating leverage, you’ll need to use the following operating leverage formula:
Operating Leverage = (Units X Contribution Margin) / (Units X Contribution Margin) – Fixed Operating Costs
The contribution margin is essentially your Price less variable cost per unit.
You can also rewrite this formula as Contribution Margin / Profit to get your operating leverage.
When using this formula, your main objective is to see what is your company’s break-even point when selling your units.
Once you identify your break-even point, you can then better price your units so you can generate a profit.
You will also see the impact of your fixed costs on your overall ability to increase your operating income.
Now, let’s see what the result of this formula tells us.
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Operating Leverage Interpretation
What does it mean when a company has a high or low operating leverage?
Operating leverage is an important measure allowing companies to determine the break-even point so they can better assess how many units they must sell to generate a profit.
A company having high operating leverage is one that has high fixed costs to assume regardless of how many units it sells.
For example, a company that requires a lot of equipment and machinery to generate sales may have loan payments to cover regular maintenance costs regardless of the number of units produced.
The company must sell enough units to be able to pay for its high fixed costs and variable costs.
On the other hand, a company with low operating leverage is one that has low fixed costs and will not need to generate high revenues to be able to regularly make its fixed-cost payments.
For example, a service company will only need to assume fixed costs like office rent and other fixed costs that may be relatively low.
This means that the company selling services beyond its low break-even point can quickly generate profits.
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Operating Leverage Risk
Investors, financial analysts, and company leadership will regularly look at the company’s operating leverage to assess the company’s risk profile.
Typically, a company that has high operating leverage will be perceived as a riskier business than one with low operating leverage.
The reason is simple.
When you have high operating leverage, it means you must assume high fixed costs.
The higher your fixed costs, the more revenues you must generate to cover your recurring fixed costs.
When operating leverage is high, the company is exposed to a greater risk of not generating enough sales to cover its fixed costs or earn profits.
Also, a company may also run the risk of facing cash flow difficulties if it does not have accurate forecasts.
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Operating Leverage Meaning FAQ
What does the degree of operating leverage mean?
The degree of operating leverage is a measure allowing companies to determine how much their operating leverage will vary based on variations in sales.
In other words, if sales go up or down by a certain percentage, what will be the impact on the company’s operating income.
What is an example of a company with high operating leverage?
Companies that have to spend a lot of money on equipment, machinery, research and development, marketing, and other fixed costs tend to have high operating leverage.
For example, Microsoft, Tesla, and similar companies spending a lot of money on research and development have high operating leverage as they must continually pay for these innovation costs.
What is an example of a company with low operating leverage?
Retail companies or service organizations tend to have low operating leverage.
For example, Walmart is a major retailer that has a low fixed cost compared to the high variable costs associated with its inventory.
Service companies do not have a lot of fixed costs to pay apart from office rent, business loans, and other fixed costs.
How can companies manage their operating leverage?
One method used by companies to manage their operating leverage is to outsource tasks and functions allowing them to change their fixed cost to variable cost ratio.
A company may choose to outsource a function that may potentially increase its fixed costs higher than what is considered a “comfortable” level.
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So there you have it folks!
What does operating leverage mean?
In a nutshell, operating leverage is a measure of how much a company’s operating income will vary when the company’s revenues vary.
With the operating leverage calculation, you can assess the volatility of a company’s operating revenue in relation to its revenues.
Having a good understanding of your operating leverage allows you to better understand the sensitivity of your operating income to increases or decreases in revenues.
For some companies, a small change in revenues can have a much larger impact on operating income (either upward or downward).
Now that you know what operating leverage is all about and how it works, good luck with your research!
I hope you enjoyed this article on Operating Leverage! Be sure to check out more articles on my blog. Enjoy!
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