Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is used to evaluate the break even point of a business, as well as the likely profit levels on individual sales. The following two scenarios describe an organization having high operating leverage and low operating leverage.
- High operating leverage. A large proportion of the company’s costs are fixed costs. In this case, the firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs.
- Low operating leverage. A large proportion of the company’s sales are variable costs, so it only incurs these costs if there is a sale. In this case, the firm earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order to cover its lower fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn outsized profits if it can generate additional sales.
For example, a software company has substantial fixed costs in the form of developer salaries, but has almost no variable costs associated with each incremental software sale; this firm has high operating leverage. Conversely, a consulting firm bills its clients by the hour, and incurs variable costs in the form of consultant wages. This firm has low operating leverage.
To calculate operating leverage, divide an entity’s contribution margin by its net operating income. The contribution margin is sales minus variable expenses.
For example, the Alaskan Barrel Company (ABC) has the following financial results:
|Net operating income||$10,000|
ABC has a contribution margin of 70% and net operating income of $10,000, which gives it a degree of operating leverage of 7. ABC’s sales then increase by 20%, resulting in the following financial results:
|Net operating income||$24,000|
The contribution margin of 70% has stayed the same, and fixed costs have not changed. Because of ABC’s high degree of operating leverage, the 20% increase in sales translates into a greater than doubling of its net operating income.
When using the operating leverage measurement, constant monitoring of operating leverage is more important for a firm having high operating leverage, since a small percentage change in sales can result in a dramatic increase (or decrease) in profits. A firm must be especially careful to forecast its revenues carefully in such situations, since a small forecasting error translates into much larger errors in both net income and cash flows.
Knowledge of the level of operating leverage can have a profound impact on pricing policy, since a company with a large amount of operating leverage must be careful not to set its prices so low that it can never generate enough contribution margin to fully offset its fixed costs.