In finance, companies assess their business risk by capturing a variety of factors that may result in lower-than-anticipated profits or losses. One of the most important factors that affect a company's business risk is operating leverage; it occurs when a company must incur fixed costs during the production of its goods and services. A higher proportion of fixed costs in the production process means that the operating leverage is higher and the company has more business risk.
When a firm incurs fixed costs in the production process, the percentage change in profits when sales volume grows is larger than the percentage change in sales. When the sales volume declines, the negative percentage change in profits is larger than the decline in sales. Operating leverage reaps large benefits in good times when sales grow, but it significantly amplifies losses in bad times, resulting in a large business risk for a company.
Consider a pharmaceutical company that produces a drug and must incur $10 million of fixed costs on special equipment. After purchasing the equipment, the company incurs only $10 of variable costs to produce one package of the drug. The company sells 1 million drug packages in a given year for a price of $25 per package. The company's management calculates the degree of operating leverage as follows: sales volume*(price - variable cost) / (sales volume * (price - variable cost) - fixed cost) = 3. If the sales volume grows by 10%, the profits increase by 10% * 3 = 30%. The opposite is true when sales volume declines by 10%: the company loses 30% in its profits on a 10% decline in sales volume.