Operating leverage is the expression of a company’s fixed costs as a percentage of its total costs.
The total cost is the sum of fixed cost (like salaries and rent) and variable cost (like wages and raw material). It can help find out how much sales will a company need to turn a profit and how much each sale affects the profit margin.
In other words, it can help determine the possible profit that can be earned on individual sales.
Operating leverage involves the analysis of the variable and fixed costs of a business. Operating leverage is the highest for companies that have a higher proportion of fixed operating costs relative to variable costs, like manufacturing companies.
This means they employ more fixed assets to run their operations. On the contrary, businesses with lower proportion of fixed operating costs will have low operating costs, like consultancy companies.
Types of Operating Leverages
Let us go through two scenarios of enterprises having low operating leverage and high operating leverage:
1. Low Operating Leverage
In this case, a business has a larger share of variable costs in total costs. It incurs variable costs only when there is a sale.
The company will earn a small profit on every incremental sale but it will not need to generate a larger sales volume to cover low fixed costs.
This type of business can earn profit at low sales volume. However, it cannot earn absurd profits even if it makes additional sales. For example, a consultancy company that charges its clients on an hourly basis will have a low operating leverage as variable costs are in wages.
2. High Operating Leverage
In this case, a business has a larger share of fixed costs in total costs.
The company will earn a more significant profit on each incremental sale but must make sufficient sales volume to cover its higher fixed costs.
If it can make substantial sales, the profit will be high after deducting its fixed cost. However, the earnings will be guided by sales volume.
For example, a software development company with fixed costs in terms of salaries but has negligible variable costs in terms of incremental sale of software will have a high operating leverage.
For calculating operating leverage of a company = (sales – variable costs) ÷ net operating income.
The (sales – variable costs) are also called contribution margin.
|Variable Costs||Rs. 30,000|
|Fixed Costs||Rs. 60,000|
|Net Operating Income||Rs 10,000|
The contribution margin is Rs, 70 000 /10, 000 or 70 %. If the sales increase by 20 %, then the new financial results would be:
|Variable Costs||Rs. 36,000|
|Fixed Costs||Rs. 60,000|
|Net Operating Income||Rs 24,000|
There is a marginal increase in variable costs while the fixed costs remain unchanged, then a 20 % increase in sales leads to a more than double jump in the net operating income.
How Does Operating Leverage Affect a Business?
Businesses assess their risks by collating several factors that may lead to higher than anticipated losses or lower than expected profits.
One of the most important factors to consider is how operating leverage can be used as an indicator of business risk.
A business faces certain risks as it must bear fixed costs in the production of goods and services. With fixed costs, an increase in sales volume leads to a greater percentage change in profits, than the corresponding percentage change in sales.
Similarly, when sales decline, the corresponding loss will be high. A higher share of fixed costs indicate higher operating leverage and increased exposure to risk.
Higher operating leverage is better than a lower one for the business as it allows for a more significant profit on every increment in the sale. However, it is more vulnerable to volatile market situations.
The profitability may last as long as the economy is showing good growth. On the other hand, a slowdown in the economy can lead to a downfall in earnings due to high fixed costs; while low operating leverage will allow profit earnings even with a low level of sales.
If using you are using operating leverage as a parameter for your business operations, constant monitoring is required as even a tiny percentage change in sales can dramatically lead to a rise or fall in profit.
The business owner needs to be careful as a small error in forecasting translates into a much larger error in the net income and cash flows. Understanding the mechanism of operating leverage is significantly helpful when setting up the pricing policy.
A business with high operating leverage must not set its prices so low that it can not generate sufficient contribution margin to offset its fixed costs completely.
Wrapping it Up
To leverage is to multiply.
The priority of the business is to maintain a balance between long term debt and equity as it can significantly affect the returns and risks. Operating leverage guides the investor and the business to operate and invest.
However, this also comes with greater risk. When considering operating leverage as the priority guiding force, it is pertinent to remember that it magnifies both gains and losses.
As a business owner, if you are considering operating leverage, it can give a lot of information about the future profitability of the company. While it may not give the whole picture, it will certainly give glimpses to it.