Definition: Operating leverage is the ratio of fixed costs to total costs in a company’s cost structure. Companies that have a fixed cost to total cost ratio or degree of operating leverage are said to have high operating leverage.
What Does Operating Leverage Mean?
Fixed costs in a manufacturing process are in some ways less desirable than variable costs because fixed costs remain regardless of the number of units produced. In other words, production levels cannot control fixed costs. This is why fixed costs tend to be one of the biggest hurdles in achieving the breakeven point on most manufacturing processes. Production managers usually try to produce at capacity as much as possible. The higher production levels spread out the fixed costs over more units and decrease the fixed cost per unit.
When producing at capacity, managers tend to favor fixed costs over variable costs because fixed costs remain constant with every new product produced. Most manufacturing companies have gravitated toward this approach of maximizing fixed costs as much as possible and raising their operating leverage.
One example of a company trying to raising its operating leverage is by automating its assembly line. Almost all car manufacturers have fully or partially automated assembly lines. The automation lowers variable costs and direct labor costs, but in turn raises fixed costs.
This makes the business operations much more risky because the car manufacturer now has to produce more products just to breakeven with the higher fixed costs and higher operating leverage. In a sense, operating leverage is a measure of operational risk because it shows how much fixed costs will have to be overcome in order to breakeven.