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Operating leverage is one of many important financial ratios used to evaluate the financial health of a company. It has great implications of managerial decision-making and is an important metric in assessing how well a business is operating financially with regard to its future cash flows. Through operating leverage, you will understand why higher fixed costs are good for incremental sales while higher variable costs means firms gain fewer from each incremental sale.
1. What is the Definition of Operating Leverage?
Operating leverage involves assessing the company’s fixed costs and variable costs with regard to sales. The degree of operating leverage (DOL) measures how well the company is using its fixed costs to generate profits (operating income) from each incremental sales. In other words, it measures how sensitive the operating income of a business is to its sales.
How exactly does operating leverage work? As you may know, a firm’s cost structure consists of fixed costs and variable costs. Fixed costs are costs that are not dependent on the level of output. Variable costs, on the other hand, are costs that vary depending on how many units of output are sold. In analyzing a company’s cost structure, it is also important to pay attention to contribution margin, defined as the difference between total sales and total variable costs. When a firm generates a high contribution margin, which means that the variable costs are low and fixed costs are better spent on generating profits. This implies that significant increases in sales are more likely to lead to substantial increase in operating income. This will become clearer when we understand the steps involved in the calculation of the degree of operating leverage.
High DOL: Fixed costs take up the majority of spaces in the company’s cost structure. The firm earns large profit on each incremental sale, hence the large contribution margin, but at the same time it has to guarantee that it will see enough units of good so that it can cover the fixed costs. Having done this, the operating income is more sensitive to incremental changes in sales.
Low DOL: Fixed costs take up the minority of spaces in the company’s cost structure. The firm earns small profit on each incremental sale, hence the low contribution margin. Because of low level of fixed cost, it is more likely to sell enough so as not to make a loss, but the operating income is less sensitive to incremental changes in sales.
Example 1
Company A for the year 2020 sells 1,000,000 products for a unit price of $10. Company A spends $1 million on R&D, another $1 million on advertising. The administrative fee for company A is $500,000 and rent is $200,000. The cost of goods sold for each unit of product is $2.
The table below shows a summary of the information regarding company A’s costs and pricing.
Variable costs | Fixed costs | Other information |
$2 per unit | R&D: $1 million | Price: $10 per unit |
Advertising: $1 million | Quantity: 1 million | |
Administrative fee: $500,000 | ||
Rent: $200,000 | ||
Sum: $2.7 million |
Applying the formula in 2, we are able to derive the degree of operating leverage at around 1.5. Now, let’s look at the company financials for the year 2020
- Revenue: $10,000,000
- Fixed expenses: $2,700,000
- Variable expenses: $2,000,000
- Net operating income: $5,300,000
Company A has an operating leverage of 1.5. In 2021, revenue is projected to increase by 20% (meaning that instead of selling 1 million products, it now sells 1.2 million units). Company A’s financials in 2021 will look like this:
- Revenue: $12,000,000
- Fixed expenses: $2,700,000
- Variable expenses: $2,400,000
- Net operating income: $6,900,000 (an increase of 30% compared to 2020’s operating income)
Example 2
Company B for the year 2020 sells 1,000,000 products for a unit price of $10. Company B spends $2 million on R&D, another $0.5 million on advertising. The administrative fee for company B is $200,000 and rent is $100,000. The cost of goods sold for each unit of product is $5.
The table below shows a summary of the information regarding company B’s costs and pricing.
Variable costs | Fixed costs | Other information |
$5 per unit | R&D: $2 million | Price: $10 per unit |
Advertising: $0.5 million | Quantity: 1,000,000 | |
Administrative fee: $200,000 | ||
Rent: $100,000 | ||
Sum: $2.8 million |
Applying the formula in 2, we are able to derive the degree of operating leverage at around 2.27, higher than company A’s 1.5. Now, let’s look at the company financials for the year 2020
- Revenue: $10,000,000
- Fixed expenses: $2,800,000
- Variable expenses: $5,000,000
- Net operating income: $2,200,000
Company B has an operating leverage of 2.27, meaning that the percentage change in B’s operating income with regard to its changes in sales is higher than that of company A. In 2021, revenue is projected to increase by 20% (meaning that instead of selling 1 million products, it now sells 1.2 million units). Company B’s financials in 2021 will look like this:
- Revenue: $12,000,000
- Fixed expenses: $2,800,000
- Variable expenses: $6,000,000
- Net operating income: $3,200,000 (an increase of 45.5% compared to 2020’s operating income)
With the same change in sales projection, a higher degree of operating leverage means a higher increase in operating income for company B.
5. What are the Business Implications of Operating Leverage?
5.1. Pricing
Owner of a business that has a high degree of operating leverage must be careful not to set the price so low that it will never be able to generate enough contribution margin to fully offset its fixed costs. He or she can also rest assured that the high price will not do harm to its bottom line, since a high DOL means that small changes in sales can even substantially increase the operating income.
5.2. Sales forecast
Businesses with high DOL also need to monitor this ratio carefully since small declines in sales can result in huge losses for the business. For these businesses, they must be extremely careful in projecting revenues since small errors can result in even bigger errors in net income and cash flows.
5.3. Economic Cycle Dependent
While a high DOL can be beneficial to firms, it also means that the business is very vulnerable to business cyclical fluctuations and macroeconomic situations. When the economy is in the boom phase, a high DOL benefits the company mostly by increasing consumer demands. However, in recessionary phases, most of the time consumer demand declines overnight and a high DOL means a lot of the business’ costs are trapped in fixed costs. With these two factors, a business’ income can plummet rapidly due to high fixed costs and low demand. Firms with high DOL are very financially risky in economic bust.
Operating leverage is a useful financial ratio used in managerial decision making. It reflects pretty well the internal strengths of the company in profit potential while also cautions business owners against external risks in the market. With that reason said, a close monitor of this ratio is beneficial for business executives or analysts who want to understand and evaluate a company.
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