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.

If fixed costs are higher in proportion to variable costs, a company will generate a high operating leverage ratio and the firm will generate a larger profit from each incremental sale. A larger proportion of variable costs, on the other hand, will generate a low operating leverage ratio and the firm will generate a smaller profit from each incremental sale. In other words, high fixed costs means a higher leverage ratio that turn into higher profits as sales increase. This is the financial use of the ratio, but it can be extended to managerial decision-making.

Definition: What is Operating Leverage?

Managers use operating leverage to calculate a firm’s breakeven point and estimate the effectiveness of pricing structure. An effective pricing structure can lead to higher economic gains because the firm can essentially control demand by offering a better product at a lower price. If the firm generates adequate sales volumes, fixed costs are covered, thereby leading to a profit. However, to cover for variable costs, a firm needs to increase its sales.

If a firm generates a high gross margin, it also generates a high DOL ratio and can make more money from incremental revenues. This happens because firms with high degree of operating leverage (DOL) do not increase costs proportionally to their sales. On the other hand, a high DOL incurs a higher forecasting risk because even a small forecasting error in sales may lead to large miscalculations of the cash flow projections. Therefore, poor managerial decisions can affect a firm’s operating level by leading to lower sales revenues.

Let’s take a look at how to calculate operating leverage.

Formula

The operating leverage formula is calculated by multiplying the quantity by the difference between the price and the variable cost per unit divided by the product of quantity multiplied by the difference between the price and the variable cost per unit minus fixed operating costs.

DOL = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Operating Costs

By breaking down the equation, you can see that DOL is expressed by the relationship between quantity, price and variable cost per unit to fixed costs. If operating income is sensitive to changes in the pricing structure and sales, the firm is expected to generate a high DOL and vice versa.

You can also rephrase this equation in more general terms like this:

Managers need to monitor DOL to adjust the firm’s pricing structure towards higher sales volumes as a small decrease in sales can lead to a dramatic decrease in profits.

Let’s look at an example.

Example

John’s Software is a leading software business, which mostly incurs fixed costs for upfront development and marketing. John’s fixed costs are \$780,000, which goes towards developers’ salaries and the cost per unit is \$0.08. The company sells 300,000 units for \$25 each. Given that the software industry is involved in the development, marketing and sales, it includes a range of applications, from network systems and operating management tools to customized software for enterprises.

Based on the company’s sales, fixed costs, and variable cost per unit, its operating leverage is calculated like this:

DOL = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Operating Costs = [300,000 x (25-0.08)] / (300,000 x (25-0.08) – 780,000 = 7,437,000 / 6,657,000 = 112% or 1.12.

This means that a 10% increase in sales will yield a 12% increase in profits (10% x 11.2 = 120%).

If the company increase sales to, let’s say, 450,000 units for \$20 each, the new DOL will be calculated like this:

[450,000 x (20-0.08)] / (450,000 x (20-0.08) – 780,000 = 8,964,000 / 8,184,000 = 110% or 1.10.

This means that a 10% increase in sales will yield an 11% increase in profits (10% x 11 = 110%), but the company generates \$1,527,000 more in sales revenues (8,964,000 -7,437,000 = 1,527,000). Note that costs remain unchanged and only by lowering the price the company increases its sales revenues.

Analysis and Interpretation

The degree of operating leverage can show you the impact of operating leverage on the firm’s earnings before interest and taxes (EBIT). Also, the DOL is important if you want to assess the effect of fixed costs and variable costs of the core operations of your business.

A high degree of operating leverage provides an indication that the company has a high proportion of fixed operating costs compared to its variable operating costs. This means that it uses more fixed assets to support its core business. It also means that the company can make more money from each additional sale while keeping its fixed costs intact. So, the company has a high DOL by making fewer sales with high margins. As a result, fixed assets, such as property, plant, and equipment, acquire a higher value without incurring higher costs. At the end of the day, the firm’s profit margin can expand with earnings increasing at a faster rate than sales revenues.

On the other hand, a low DOL suggests that the company has a low proportion of fixed operating costs compared to its variable operating costs. This means that it uses less fixed assets to support its core business while sustaining a lower gross margin.

It is important to understand that controlling fixed costs can lead to a higher DOL because they are independent of sales volume. The percentage change in profits as a result of changes in the sales volume is higher than the percentage change in sales. This means that a change of 2% is sales can generate a change greater of 2% in operating profits.

Practical Usage Explanation: Cautions and Limitations

At the end of the day, operating leverage can tell managers, investors, creditors, and analysts how risky a company may be. Although a high DOL can be beneficial to the firm, often, firms with high DOL can be vulnerable to business cyclicality and changing macroeconomic conditions.

When the economy is booming, a high DOL may boost a firm’s profitability. However, companies that need to spend a lot of money on property, plant, machinery, and distribution channels, cannot easily control consumer demand. So, in the case of an economic downturn, their earnings may plummet because of their high fixed costs and low sales.