Operating Leverage

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What is 'Operating Leverage'

Operating leverage is a measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. A business that makes sales providing a very high gross margin and fewer fixed costs and variable costs has much leverage. The higher the degree of operating leverage, the greater the potential danger from forecasting risk, where a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.

Operating Leverage = Contribution Margin / Net Operating Income

BREAKING DOWN 'Operating Leverage'

Operating leverage may be used for calculating a company’s breakeven point and substantially affecting profits by changing its pricing structure. Because businesses with higher operating leverage do not proportionately increase expenses as they increase sales, those companies may bring in more revenue than other companies. However, businesses with high operating leverage are also more affected by poor corporate decisions and other factors that may result in revenue decreases.

High and Low Operating Leverage

It is essential to compare operating leverage among 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 determined.

Most of a company’s costs are fixed costs that occur 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 incurred when sales occur. The business earns less profit on each sale but needs a lower sales volume for covering fixed costs. However, the business does not generate greater profits unless it increases its sales volume.

For example, a software business has greater fixed costs in developers’ salaries, and lower variable costs with software sales. Therefore, the business has high operating leverage. In contrast, a computer consulting firm charges its clients hourly, resulting in variable consultant wages. Therefore, the business has low operating leverage.

Calculating Operating Leverage

The formula for operating leverage is:

Degree of Operating Leverage = Contribution Margin (CM) / Net Operating Income (NOI) = (Revenue - Total Variable Cost) / Net Operating Income = Quantity x (Price - Variable Cost per Unit) / [Quantity x (Price - Variable Cost per Unit) - Fixed Operating Cost]

For example, Company A sells 500,000 products for $6 each. The company’s fixed costs are $800,000. It costs $0.05 per unit to make each product. Company A’s degree of operating leverage 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% revenue increase should result in a 13.7% increase in operating income (10% x 1.37 = 13.7%).

Examples of Operating Leverage

Most of Microsoft’s costs are fixed, such as expenses for upfront development and marketing. With each dollar in sales revenue earned beyond the breakeven point, the company makes a profit. Therefore, Microsoft has high operating leverage.

Conversely, Walmart retail stores have low fixed costs and large variable costs, especially for merchandise. Because Walmart stores pay for holding the items they sell, the cost of goods sold increases as sales increase. Therefore, Walmart stores have low operating leverage.