How effective is your business at using fixed assets to support core business functions? The operating leverage formula could help you find the answers you’re looking for. So, what is operating leverage, and what does the operating leverage ratio mean for your business? Learn more about the operating leverage calculation, starting with our operating leverage definition.
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.
Should my firm aim for a high or low operating leverage ratio?
Generally speaking, high operating leverage is better than low operating leverage, as it allows businesses to earn large profits on each incremental sale.
Having said that, companies with a low degree of operating leverage may find it easier to earn a profit when dealing with a lower level of sales. In addition, high operating leverage may be more vulnerable to changing macroeconomic conditions. While the economy is in good shape, these firms may experience increased profitability. However, an economic downturn can lead to plummeting earnings due to their high fixed costs.
Understanding the operating leverage formula
There’s a straightforward operating leverage formula that you can use to calculate this financial metric:
Operating Leverage = (Quantity x (Price – Variable Cost Per Unit)) / ((Quantity x (Price – Variable Cost Per Unit)) – Fixed Operating Costs)
The operating leverage formula can also be expressed in a simpler manner:
Operating Leverage = (Sales – Variable Costs) / Profits
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:
(590,000 x (30 – 0.15)) / ((590,000 x (30 – 0.15)) - 550,000) = 103%
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.
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