Operating leverage is the fraction of a company's costs that are fixed. Firms with a lower fraction of variable costs and a higher fraction of fixed costs have a higher operating leverage, which means many costs can't be scaled down in periods of declining sales. This increases the risk of loss and makes operating profit less predictable. However, operating leverage is not necessarily bad. Though it magnifies losses when sales decline, it can increase profit in periods of sales growth.
Operating leverage definition
The operating leverage calculation helps you measure what percentage of your business's total costs are constituted by fixed and variable costs. This enables you to determine how effectively your company is using fixed costs to generate profits. Consequently, you can use the operating leverage equation to determine your firm's breakeven point and understand the degree to which your company can increase its operating income by increasing revenue.
If a business has a high degree of operating leverage, it's a reliable indication that its proportion of fixed to variable costs is high. As such, the business is using more fixed assets to support its core business. Ultimately, this means that the business will be able to expand its profit margin more quickly. High operating leverage businesses will need to maintain high sales to cover their fixed costs. A low degree of operating leverage points the other way, indicating that the firm uses more variable assets to support the core business, leading to a lower gross margin.
Real-Life Examples of Operating Leverage
The best way to explain operating leverage is by way of examples. Take, for example, a software maker such as Microsoft. The bulk of this company's cost structure is fixed and limited to upfront development and marketing costs. Whether it sells one copy or 10 million copies of its latest Windows software, Microsoft's costs remain basically unchanged. So, once the company has sold enough copies to cover its fixed costs, every additional dollar of sales revenue drops into the bottom line. In other words, Microsoft possesses remarkably high operating leverage.
By contrast, a retailer such as Walmart demonstrates relatively low operating leverage. The company has fairly low levels of fixed costs, while its variable costs are large. Merchandise inventory represents Walmart's biggest cost. For each product sale that Walmart rings in, the company has to pay for the supply of that product. As a result, Walmart's cost of goods sold (COGS) continues to rise as sales revenues rise.
Operating Leverage and Profits
By examining how sensitive a company's operating income is to a change in revenue streams, the degree of operating leverage directly reflects a company's cost structure, and cost structure is a significant variable when determining profitability. If fixed costs are high, a company will find it difficult to manage short-term revenue fluctuation, because expenses are incurred regardless of sales levels. This increases risk and typically creates a lack of flexibility that hurts the bottom line. Companies with high risk and high degrees of operating leverage find it harder to obtain cheap financing.
In contrast, a company with relatively low degrees of operating leverage has mild changes when sales revenue fluctuates. Companies with high degrees of operating leverage experience more significant changes in profit when revenues change.
Higher fixed costs lead to higher degrees of operating leverage; a higher degree of operating leverage creates added sensitivity to changes in revenue. A more sensitive operating leverage is considered more risky, since it implies that current profit margins are less secure moving into the future.
While this is riskier, it does mean that every sale made after the break-even point will generate a higher contribution to profit. There are fewer variable costs in a cost structure with a high degree of operating leverage, and variable costs always cut into added productivity—though they also reduce losses from lack of sales.
Operating leverage can tell investors a lot about a company's risk profile. Although high operating leverage can often benefit companies, companies with high operating leverage are also vulnerable to sharp economic and business cycle swings.
As stated above, in good times, high operating leverage can supercharge profit. But companies with a lot of costs tied up in machinery, plants, real estate and distribution networks can't easily cut expenses to adjust to a change in demand. So, if there is a downturn in the economy, earnings don't just fall, they can plummet.
Consider the software developer Inktomi. During the 1990s, investors marveled at the nature of its software business. The company spent tens of millions of dollars to develop each of its digital delivery and storage software programs. But thanks to the internet, Inktomi's software could be distributed to customers at almost no cost. In other words, the company had close to zero cost of goods sold. After its fixed development costs were recovered, each additional sale was almost pure profit.
After the collapse of dotcom technology market demand in 2000, Inktomi suffered the dark side of operating leverage. As sales took a nosedive, profits swung dramatically to a staggering $58 million loss in Q1 of 2001—plunging down from the $1 million profit the company had enjoyed in Q1 of 2000.34
The high leverage involved in counting on sales to repay fixed costs can put companies and their shareholders at risk. High operating leverage during a downturn can be an Achilles heel, putting pressure on profit margins and making a contraction in earnings unavoidable. Indeed, companies such as Inktomi, with high operating leverage, typically have larger volatility in their operating earnings and share prices. As a result, investors need to treat these companies with caution.
Understanding the operating leverage formula
There's a straightforward operating leverage formula that you can use to calculate this financial metric:
The operating leverage formula can also be expressed in a simpler manner:
Example of an operating leverage calculation
To understand how the operating leverage equation works in practice, let's look at an example.
Imagine that Company A mostly incurs fixed costs, which come to £550,000. If the cost per unit is £0.15 and the business sells 590,000 for £30, you can calculate the operating leverage like so:
In other words, a 10% increase in sales will lead to a 10.3% increase in revenue.
Why is the operating leverage equation important?
The operating leverage calculation is necessary because it can help you understand the appropriate price-point for covering your costs and generating a profit. Furthermore, it can help you understand how effectively your business can use fixed-cost items, such as machinery or warehousing, to generate profits. Simply put, if you can eke more profits from your fixed assets, you'll be able to improve your operating leverage.
The airline industry exhibits high operating leverage. Their fixed costs include aircraft leases and wages for staff for their routes. These high fixed costs make profit (or loss) extremely sensitive to sales volume. Aside from operating leverage, competition within the industry is very intense. These factors make air travel a tough business that suffers periods chronic losses and sometimes drives airline companies into bankruptcy.
Business risk is only one component of a company's total risk. Financial risk is another important component. The use of debt funding is called financial leverage. Like operating leverage, financial leverage magnifies positive and negative returns. Usually, management determines and controls operating leverage and financial leverage. Management should carefully weigh the risks and rewards associated with either kind of leverage.