what is operating leverage?

hi

Operating leverage is 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.

Operating leverage may be used for calculating a company’s break-even point and substantially affecting profits by changing its pricing structure.

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 determined.

The business earns less profit on each sale but needs a lower sales volume for covering fixed costs.

Quantity x (Price - Variable Cost per Unit) / [Quantity x (Price - Variable Cost per Unit) - Fixed Operating Cost]

Extent to which a firm commits itself to high levels of fixed operating costs (which vary with time, such as insurance, rent, salaries but not interest) as compared with the levels of variable costs (which vary with volume, such as for energy, labor, material). Firms with high operating leverage have high breakeven points but (when the breakeven point is crossed) they show a greater increase in operating income with every increase in sales revenue (and greater losses with every drop in sales revenue) in comparison with firms with low operating leverage. Also called operation gearing, it is one of the major components of operating risk.

With each dollar in sales revenue earned beyond the break-even point, the company makes a profit. Therefore, Microsoft has high operating leverage.

operating leverage is a financial efficiency ratio used to measure what percentage of total costs are made up of fixed costs and variable costs in an effort to calculate how well a company uses its fixed costs to generate profits.

– Operating leverage is a measure of how sensitive the operating income is to the change in revenues. Alternatively, Operating leverage can be defined as the capability of the firm to use its fixed expenses to generate better returns.

We note from the above graph that companies like Accenture, Cognizant, Automatic Data Processing and Paychex have lower Leverage (~1.0x), whereas, companies like Delta Airlines, China Eastern Airlines, and National Grid have a higher Leverage.

Operating leverage is a measure of the combination of fixed costs and variable costs in a company’s cost structure. A company with high fixed costs and low variable costs has high operating leverage;

Operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky, or volatile, a company's operating income is.

Here is the formula for operating leverage:

Operating Leverage = [Quantity x (Price - Variable Cost per Unit)] / Quantity x (Price - Variable Cost per Unit) - Fixed Operating Cost

Operating Leverage = [1,000,000 x ($12 - $0.10)] / 1,000,000 x ($12 - $0.10) - $10,000,000 = $11,900,000/$1,900,000 = 6.26 or 626%

WHY DOES OPERATING LEVERAGE MATTER?

In a sense, operating leverage is a means to calculating a company's breakeven point. However, it's also clear from the formula that companies with high operating leverage ratios can essentially make more money from incremental revenues than other companies, because they don't have to increase costs proportionately to make those sales.

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.

n a sense, operating leverage is a means to calculating a company's breakeven point. However, it's also clear from the formula that companies with high operating leverage ratios can essentially make more money from incremental revenues than other companies, because they don't have to increase costs proportionately to make those sales.

Accordingly, companies with high operating leverage ratios are poised to reap more benefits from good marketing, economic pickups, or other conditions that tend to boost sales.

Operating leverage may be used for calculating a company’s break even point and substantially affecting profits by changing its pricing structure.

operating leverage do not proportionately increase expenses as they increase sales, those companies may bring in more revenue than other companies.