What is Operating Leverage?
Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating 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.
The Operating Leverage And DOL
The Formula for Operating Leverage
Which can be restated as:
Q = unit quantity
CM = contribution margin (price - variable costs per unit)
Calculating Operating Leverage
For example, Company A sells 500,000 products for a unit price of $6 each. The company’s fixed costs are $800,000. It costs $0.05 in variable costs per unit to make each product.
Aclculate company A’s degree of operating leverage as follows:
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%).
What Does Operating Leverage Tell You?
The operating leverage formula is used to calculate a company’s break-even point and help set appropriate selling prices to cover all costs and generate a profit. The formula can reveal how well a company is using its fixed-cost items, such as its warehouse and machinery and equipment, to generate profits. The more proift a company can squeeze out of the same amount of fixed assets, the higher its operating leverage.
One conclusion companies can learn from examning operating leverage is that firms that minimize fixed costs can increase their profits without making any changes to selling price, contribution margin or the number of untis they sell.
High and Low Operating Leverage
It is key 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 defined.
Most of a company’s costs are fixed costs that reoccur each month such as building rent, 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 that are only incurred when sales occur. This includes labor to assemble products and the cost of raw materials that are made into products. Some companis earn less profit on each sale but can have a lower sales volume and still generate enough to cover fixed costs.
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, and doesn't need expensive ffice space because its consultants work in clients' offices. This results in variable consultant wages and low fixed operating costs. Therefore, the business has low operating leverage.
- Companies with high operating leverage must cover a larger amount of fied costs each month regardless of whether they sell any units of product.
- Low-operating-leverage companies may have high costs that vary directly with their sales, but have lower fixed costs to cover each month.
- The operating leverage formula can show how a company's costs and profit relate to each other, and show that reducing fixed costs can increase profits without changing sales quantity, contribution margin or selling price.
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 break-even point, the company makes a profit, but Microsoft has high operating leverage.
Conversely, Walmart retail stores have low fixed costs and large variable costs, especially for merchandise. Because Walmart sells a huge volume of units and pays upfront for the items it sells, its cost of goods sold increases as sales increase. Because of this, Walmart stores have low operating leverage.