Operating leverage looks at the relationship between a company’s fixed costs (e.g. rent), its variable costs (e.g. shipping), and revenue. The higher a company’s fixed costs relative to its variable costs indicates a high operating leverage.
Knowing whether a company’s operating leverage is high or low is important because those two factors, when taken into account with revenue, have an impact on profitability. A company with higher fixed costs has a higher degree of operating leverage (DOL), which then determines how much revenue is needed after costs are met — i.e. after the break-even point — to make a profit.
Operating Leverage Definition
The definition of operating leverage is fairly straightforward: It’s the amount of a company’s fixed costs relative to its variable costs. But the impact of operating leverage is best understood in relation to revenue.
That’s because a company with lower fixed costs has a lower break-even point before revenue begins to generate a profit. A company with higher fixed costs, i.e. higher operating leverage, has to work harder to cover its fixed costs and reach that break-even point. What are some of those costs?
Fixed Costs and Variable Costs
Many people are familiar with the idea of a fixed expense vs. a variable expense, as these apply to everyday life as they do in business.
• Fixed expenses. These are certain business expenses that rarely vary, like commercial rent, for example. It doesn’t matter how much a company earns or loses in a given month, the amount of rent owed on their lease is set at a fixed rate until the contract expires.
Fixed expenses tend to be related to time: e.g. X salaries per year for X employees, the cost of liability insurance, loan payments.
• Variable expenses. These expenses are related to the selling of a product or service, e.g. inventory and shipping costs, or marketing and sales. Another would be a “work for hire” employee who may or may not stay with the company.
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Examples of Hybrid Semi-variable and Semi-fixed Costs
Sometimes costs blend together to create semi-fixed or semi-variable costs. For instance, a business may promise a plant supervisor a weekly salary of $1,500, plus 1% of the cost price for every widget produced under that manager’s supervision.
The fixed cost is the manager’s weekly salary of $1,500. That remains the same from pay period to pay period.
The variable cost is the 1% unit production percentage paid to the manager as an income incentive. That 1% payout is largely unknowable when the promise is made, making it a variable cost.
In another example, a company may pay its corporate finance manager a salary, which represents a fixed cost. Yet that same company may also pay its line workers on a production basis, based on a per-product wage formula. In that scenario, the same company may have dual fixed and variable costs in the same cost pipeline (i.e., salaries and wages), making those costs semi-variable and semi-fixed costs.
When trying to understand a business’s profitability and scalability, combining different metrics with operating leverage, like the asset turnover ratio, may also be helpful.
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Understanding the Degree of Operating Leverage (DOL)
Since every business deals with a combination of fixed and variable expenses, understanding the degree of operating leverage is the next step in gauging a company’s path to profitability.
When a company has higher fixed costs, the break-even point is also higher. But once that point is reached, every additional dollar in revenue has the potential to generate more profit because fixed costs stay the same, regardless of changes in production (volume).
When a company’s variable costs are higher the break-even point may be lower, but additional revenue also potentially drives up the variable costs (because those costs rise as volume rises). This impacts profitability.
High Operating Leverage and Low Operating Leverage: A Comparison
Some industries tend to have a higher DOL and some tend to have a lower DOL. Those with higher fixed costs often include leases for land or buildings, or heavy R&D. Retailers are among those with lower fixed costs vs. their much higher variable costs (merchandise is pretty variable).
| High Degree of Operating Leverage | Low Degree of Operating Leverage |
|---|---|
| Airlines and automotive | Food services (e.g. restaurants) |
| Energy | Retailers (e.g. fashion) |
| Telecommunications | Professional services |
| Pharmaceuticals | Ecommerce |
For example an airline has high fixed costs: It has to maintain a fleet of aircraft, pay fuel, salaries, insurance, and so on. A consulting firm has higher variable costs — i.e. the salaries and commissions of its consultant staff.
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Operating Leverage Formula
The operating leverage formula is a useful way to compare companies within the same industry.
Mathematically, the formula for operating leverage looks like this:
Operating Leverage = [Quantity (Price – Variable Cost per Unit)] / Quantity (Price – Variable Cost per Unit) – Fixed Operating Cost
Example Scenario and Calculation
For example, say Firm ABC has sold 1,000,000 hammers for $12 each. Firm ABC also has $10,000,000 worth of fixed costs, for expenses for machinery, office equipment, employees, among other costs. With unit sales at $12 each and $10 million in fixed costs, Firm ABC pays $0.10 per unit to make each hammer.
Here’s what that equation looks like in mathematical terms, and what the operational leverage outcome winds up being:
Operating Leverage = [1,000,000 x ($12 – $0.10)] / 1,000,000 x ($12 – $0.10) – $10,000,000 = $11,900,000/$1,900,000 = 6.26 or 626%
Based on that calculation, a 10% increase in revenue will result in a 62.6% operating income (i.e. profit) increase for Firm ABC.
But if you ran the numbers for Company XYZ, another hammer manufacturer, with different fixed costs and different variable costs, the amount of profit generated by an increase in revenue would also be different — and this could provide an important point of comparison for investing in one company vs. another.
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How to Use Operating Leverage
Operating leverage helps to determine a few things. First, it’s used to measure the break-even point for a company. That’s the point at which expenses are covered and profit is zero — knowing this can help set appropriate per-unit prices.
That’s because changes in revenue naturally impact operating income, but calculating the DOL can reveal what that means for individual companies: i.e. how much will a 10% change in revenue affect profit? A high DOL company might see higher profits once fixed costs are covered. But if revenue decreases, there would be downward pressure on its margins.
Knowing the DOL can also help assess whether a company is getting the most out of its fixed-cost assets (e.g. the cost of the factory, machinery, maintenance), or are there efficiencies that might help generate higher operating income (profit)? By managing fixed cost items better, a company might increase profits without needing to move other levers like price or number of units sold.
The Takeaway
Operating leverage is an important metric in business. It can help analysts or investors better understand a company’s fixed costs relative to its variable costs, and how revenue will impact profit owing to the difference in break-even points.
For example, a company with higher fixed costs has higher operating leverage than a company with higher variable costs. So the higher DOL company will see a substantive change in profits as sales increase past the break-even point.
A company with higher variable costs (and lower operating leverage) will see a smaller profit on each sale — but because it has lower fixed costs, it likely won’t need to increase sales as much to cover those items.
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FAQ
What does it mean to have high operating leverage?
When a company has higher fixed costs it’s said to have a higher degree of operating leverage. This means the break-even point for that company is also higher. After that point, every additional dollar in revenue has the potential to generate more profit because fixed costs stay the same, regardless of changes in production (volume).
What does it mean to have low operating leverage?
When a company’s variable costs are higher, it has lower operating leverage (i.e. lower fixed costs). In that case the break-even point for that company is lower, and a lower proportion of additional revenue will go toward profit, because variable costs go up as sales rise.
How do you improve operating leverage?
One way to improve operating leverage is to reduce fixed costs where possible. This will lower the break-even point for a company and potentially increase profits. That said, different companies are structured differently, and improving operating leverage may require changes in variable costs versus a company that will benefit by lowering its fixed costs.
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