Operating LeverageDefined along with Formula & How to Calculate

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What is Operating Leverage?

Operating Leverage is a financial formula describing the relationship between the company’s operating income and its generated revenue.

It is a sub-topic in cost accounting that measures the direct relationship between operating income and revenue. 

A company must achieve a high gross margin rate and a low variable cost percentage to achieve high operating leverage.

Understanding Operating Leverage

When the degree of operating leverage is high, the forecasting risk could also be high because a mistake in forecasting the sales amount could result in significant changes to the cash flow projections. 

The Operating Leverage formula is:

operating leverage

Another formula to compute the Operating Leverage is:

degree of operating leverage
Fixed Costs have a significant role in computing operating leverage.

It remains constant regardless of the status of business operations.

It means that any change in the sales percentage will directly affect the percentage change in profit.

Examples of fixed costs are machinery, equipment, production facility, etc.

Through the operating leverage, the company may compute its break-even point and determine the product selling price to achieve a profitable rate and cover all the necessary expenses of the company. 

Through the operating leverage computation, several companies have concluded that since the fixed cost is the great manipulator of a profitable outcome, they can reduce or eliminate some fixed costs to arrive at a higher profit. 

Example

Green Flavors, Inc. shop sells its 50,000 pcs produced tea bags for $5 each.

The costs incurred during the production process include variable costs of $.30 per unit and fixed costs of $50,000.

Below is the computation for Green Flavors’ Operating Leverage:

Operating Leverage =  50,000 * ($5 – $.30) / (50,000 * ($5 – $.30)) – $ 50,000

Operating Leverage = 1.27 or 127%

If there is a 10% increase in revenue, a corresponding 12.7%  increase in net income will follow.

High and Low Operating Leverage

Consideration of fixed costs is significant when computing the company’s operating leverage.

For analysis and monitoring of business performance, a company may compare its financial operations with companies of the same industry, and they may choose to deep dive into how other companies manage their costs. 

To achieve a positive profit margin, the company must earn a rate greater than its costs rate.  

The other type of cost is the variable cost.

This cost has a direct relationship with sales – for every increase in sales percentage, variable costs percentage will also increase, and vice versa.

Examples of variable costs are raw materials used in production, labor costs, etc. A company may still earn even if only a few product quantities have been sold.

For example, a software company invested in building its office to add more developers and make a convenient space for them to work.

As such, the company can incur high fixed costs from the costs attached to the building and the salaries of their developers as compared to incurring variable costs.

Unlike a software consultancy company, it can tend to have a lower fixed cost because only a small office space is needed for consultants.

The software consultancy will be able to have much lower fixed and variable costs which can result in low operating leverage. 

A real-world example is Microsoft Company, which spends most of its money on product development and marketing.

The categorization of such are fixed costs and results in high operating leverage. 

Walmart company incurs a low percentage of fixed costs but a high percentage of variable costs due to its high quantities of sold items.

The products sold directly affect the company’s variable costs resulting in a higher percentage of the cost of goods sold which will then result in low operating leverage. 

What Does Operating Leverage Tell You?

Through operating leverage, the company may compute its break-even point.

Also, it guides the company in appropriately setting the selling price to cover fixed costs and still earn a profit.

The popular fixed costs items are machinery, equipment, office building, production facility, etc. 

The operating leverage computation tells the company that when fixed costs are minimized, it will be able to generate a higher profit percentage without having to make changes in the amount of the selling price, quantities to sell, or the contribution margin.

What Is the Degree of Operating Leverage (DOL)?

The Degree of Operating Leverage is a type of measure, usually in multiples, that states the operating income change relative to a change in sales.

Companies with a greater amount of fixed costs than variable costs result in high operating leverage and vice versa.

The operating leverage can be used as analyzation tool for cost management. 

What Are Examples of High and Low Operating Leverage?

Companies with high operating leverage have a high amount of fixed costs.

Most of the acquired fixed costs are related to product research and development or marketing/advertising costs.

The company may only earn a profit if there is an excessive amount of the generated sales after deduction of the fixed cost.

Companies with low operating leverage are those that are sales volume dependent. For every sale made, a corresponding variable cost is also recognized.

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