Operating Leverage

AAA

DEFINITION of 'Operating Leverage'

A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs.

1. A business that makes few sales, with each sale providing a very high gross margin, is said to be highly leveraged. A business that makes many sales, with each sale contributing a very slight margin, is said to be less leveraged. As the volume of sales in a business increases, each new sale contributes less to fixed costs and more to profitability.

2. A business that has a higher proportion of fixed costs and a lower proportion of variable costs is said to have used more operating leverage. Those businesses with lower fixed costs and higher variable costs are said to employ less operating leverage.

VIDEO

Loading the player...

BREAKING DOWN 'Operating Leverage'

The higher the degree of operating leverage, the greater the potential danger from forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be magnified into large errors in cash flow projections. The opposite is true for businesses that are less leveraged. A business that sells millions of products a year, with each contributing slightly to paying for fixed costs, is not as dependent on each individual sale.

For example, convenience stores are significantly less leveraged than high-end car dealerships.

RELATED TERMS
  1. Cash Flow

    The net amount of cash and cash-equivalents moving into and out ...
  2. Degree Of Financial Leverage - ...

    A ratio that measures the sensitivity of a company’s earnings ...
  3. Fixed Cost

    A cost that does not change with an increase or decrease in the ...
  4. Margin

    1. Borrowed money that is used to purchase securities. This practice ...
  5. Variable Cost

    A corporate expense that varies with production output. Variable ...
  6. Leverage

    1. The use of various financial instruments or borrowed capital, ...
Related Articles
  1. Markets

    ROA And ROE Give Clear Picture Of Corporate Health

    Both measure performance, but sometimes they tell a very different story. This is why they’re best used together.
  2. Options & Futures

    Home-Equity Loans: The Costs

    Learn the factors to consider when comparing the different programs offered by various lenders.
  3. Investing

    Operating Leverage Captures Relationships

    Find out how fixed and variable costs interact to shed new light on old companies.
  4. Markets

    Introduction To Fundamental Analysis

    Learn this easy-to-understand technique of analyzing a company's financial statements and reports.
  5. Stock Analysis

    How Rollins Inc. Transformed from Radio to Pest Control

    Discover how Rollins, Inc. grew and expanded, making numerous acquisitions, transitioning from the radio industry to the pest control industry.
  6. Term

    Understanding the Maintenance Margin

    A maintenance margin is the minimum amount of equity that must be kept in a margin account.
  7. Technical Indicators

    Key Financial Ratios to Analyze Investment Banks

    Find out which financial ratios are most useful when analyzing an investment bank, and why tracking capital efficiency is especially important.
  8. Professionals

    Career Advice: Management Consulting Vs. Private Equity

    Compare the career paths of management consulting and private equity, using criteria such as skills needed, starting salary and work-life balance.
  9. Trading Strategies

    Financial Ratios to Spot Companies Headed for Bankruptcy

    Obtain information about specific financial ratios investors should monitor to get early warnings about companies potentially headed for bankruptcy.
  10. Brokers

    10 Most Famous Public Companies That Went Private

    Here’s a list of the most popular listed companies that went private in recent decades.
RELATED FAQS
  1. How can a firm bring down its operating leverage?

    A company with a lower percentage of fixed costs and a higher percentage of variable costs uses less operating leverage. ... Read Full Answer >>
  2. What is the difference between operating leverage and financial leverage?

    Operating leverage and financial leverage both magnify the changes that occur to earnings due to fixed costs in a company’s ... Read Full Answer >>
  3. What are the risks of having both high operating leverage and high financial leverage?

    In finance, the term leverage arises often. Both investors and companies employ leverage to generate greater returns on their ... Read Full Answer >>
  4. What does a futures contract cost?

    The value of a futures contract is derived from the cash value of the underlying asset. While a futures contract may have ... Read Full Answer >>
  5. Are there leveraged ETFs that follow the retail sector?

    There are many exchange-traded funds (ETFs) that track the retail sector or elements of the retail sector, and some of those ... Read Full Answer >>
  6. What are some common cash-debt strategies that occur during a spinoff?

    Cash-debt strategies that are commonly used to in a spinoff to enable the parent company to monetize the spinoff are debt/equity ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Election Period

    The period of time during which an investor who owns an extendable or retractable bond must indicate to the issuer whether ...
  2. Shanghai Stock Exchange

    The largest stock exchange in mainland China, the Shanghai Stock Exchange is a nonprofit organization run by the China Securities ...
  3. Dead Cat Bounce

    A temporary recovery from a prolonged decline or bear market, followed by the continuation of the downtrend. A dead cat bounce ...
  4. Bear Market

    A market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment ...
  5. Alligator Spread

    An unprofitable spread that occurs as a result of large commissions charged on the transaction, regardless of favorable market ...
  6. Tiger Cub Economies

    The four Southeast Asian economies of Indonesia, Malaysia, the Philippines and Thailand. Tiger cub economy indicates that ...
Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!