Operating Leverage: Definition, Formula & Calculation
There can be several different ways for you to determine how your business is doing and find potential risk factors. Everything from price-to-earnings ratios, free cash flow and return on equity are just a few. That said, operating leverage is another way to help increase your profit growth and gain some financial leverage.
Operating leverage happens when you incur fixed costs throughout the production of your product or service. Having a higher proportion of fixed costs can indicate higher operating leverage, meaning more risk.
Below you will find everything you need to know about operating leverage. Including a formula and calculation examples.
Here’s What We’ll Cover:
What Is Operating Leverage?
Your accounting and bookkeeping processes require a ton of attention to detail. And when it comes to operating leverage, it lets you analyze your fixed costs and variable costs. Businesses that have a high proportion of fixed operating costs tend to have higher operating leverage.
In this case, the business in question would use more fixed assets as it operates. It also works oppositely. Let’s say that your business has a low proportion of fixed operating costs compared to your variable operating costs. You would have lower operating leverage.
To keep things simple, operating leverage is a way to measure your fixed costs as a percentage of your total costs. It can get used to help evaluate your business’s breakeven point. As well as what you can expect your profit levels to be on individual sales.
Think about this: if your business has higher operating leverage, you’re able to earn more money from each sale. This is because you don’t have to increase your costs to produce more sales. When business starts to increase, all your fixed assets such as property, plant and equipment can do more.
Plus, the existing workers that you have can produce more products since you don’t have to add a whole bunch of additional expenses. This leads to higher profit margins and the ability for earnings to increase substantially.
High Operating Leverage
When you have a high operating leverage situation, it means that your business is going to have a large proportion of fixed costs. When this happens, you can earn a bigger profit for each incremental sale. However, for this to happen you need to have a substantial enough sales volume to cover the fixed costs.
Low Operating Leverage
Having low operating leverage means that your business has a large proportion of variable costs. This is since you only incur these variable costs when you make a sale. You will earn a smaller profit on the sales that you make.
Yet, you don’t have to generate a higher amount of sales volume to be able to cover your lower fixed costs. Basically, it can be easier to earn a profit at lower sales levels, you just won’t earn outsized profits if you generate additional sales.
How to Calculate Operating Leverage
When your business has fixed costs that you need to meet, regardless of sales volume, operating leverage happens. Fixed costs lead to a percentage change in your profits when you have a change in sales volume. The percentage change in profits is greater than the percentage change in sales.
Basically, a small change of 1% in your sales will produce a change of greater than 1% in your operating profit. Measuring this gets referred to as the degree of operating leverage (DOL). It shows how much your operating profits will fluctuate based on a change in sales volume.
It breaks down the expected profits you can earn if sales volume changes. Simply put, the degree of operating leverage is the percentage change in your income. Which is taken as earnings before interest and tax.
You then divide that by the percentage change of sales output. The degree of operating leverage formula would look like this:
Degree of Operating Leverage = Q (P - V) / Q (P - V) - F
- Q is equal to the quantity that you produce or sell
- V is equal to the variable cost per unit
- P is equal to the sales price
- F is equal to your fixed operating costs
Let’s take a closer look at the formula with an example calculation.
Your business decides to invest $10,000 into marketing and development for a new product, which you’re going to end up selling for $50. It costs you a total of $5 to sell each product, and you end up with a sales volume of 1,000 products.
- Q = 1,000 products
- V = $5
- P = $50
- F = $100
1,000 (50 - 5) / 1,000 (50 - 5) - 10,000 = 45,000 / 35,000 = 1.28
You end up with a degree of operating leverage of 1.28. But, you can take this even further to determine the percentage change in operating profit.
For this example, let’s say that you have a 25% change in your sales volume.
Multiplying your DOL by your 25% change in sales volume would give you a 32% change in your operating profit.
1.28 x 25% = 32%
When it comes to the finances of your business there can be several ways to assess risk. There is a wide range of factors that can result in profits or losses that weren’t anticipated. One of the biggest factors is your operating leverage.
Operating leverage happens when you incur fixed costs of production for your product or service. Having a higher proportion of fixed costs indicates higher operating leverage, meaning more economic risk exposure. This also leads to more costly production and can limit the rate of return.
Simply put, operating leverage is a cost-accounting formula. You can use it to help measure if a business can increase operating income through increasing revenue. Any business that’s able to have sales increase with a high gross margin compared to low variable costs will have high operating leverage.
On the flip side, a business with lower operating leverage might have higher costs that can vary depending on their sales. But, they will also have fewer fixed costs that they incur each month. Keep an eye on operating leverage to limit financial constraints and increase corporate profits.
Using accounting software can also help make sure your sales revenue stays on track. It can also help reduce variable expenses and ensure you don't have dramatic increases with future costs.
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