Investopeadia: What is 'Operating Leverage'?

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.
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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 quantity x (price - variable cost per unit) / quantity x (price - variable cost per unit) - fixed operating cost = operating leverage. 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 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.
Fixed Cost
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A fixed cost is a cost that does not change with an increase or decrease in the amount of goods or services produced or sold. Fixed costs are expenses that have to be paid by a company, independent of any business activity. It is one of the two components of the total cost of running a business, along with variable cost.
BREAKING DOWN 'Fixed Cost'
A fixed cost is an operating expense of a business that cannot be avoided regardless of the level of production. Fixed costs are usually used in breakeven analysis to determine pricing and the level of production and sales under which a company generates neither profit nor loss. Fixed costs and variable costs form the total cost structure of a company, which plays a crucial role in ensuring its profitability.

Examples of Fixed Costs

Accountants perform extensive analysis of different expenses to determine whether they are variable or fixed. Higher fixed costs in the total cost structure of a company require it to achieve higher levels of revenues to break even. Fixed costs must be incurred regularly, and they tend to show little fluctuations from period to period. Examples of fixed costs include insurance, interest expense, property taxes, utilities expenses and depreciation of assets. Also, if a company pays annual salaries to its employees irrespective of the number of hours worked, such salaries must be counted as fixed costs. A company's lease on a building is another common example of fixed costs, which can absorb significant funds especially for retail companies that rent their store premises.
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