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Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Operating Leverage

What it is:

Operating leverage is the ratio of a company's fixed costs to its variable costs

How it works (Example):

Here is the formula for operating leverage:

Operating Leverage = [Quantity x (Price - Variable Cost per Unit)] / Quantity x (Price - Variable Cost per Unit) - Fixed Operating Cost

To see how operating leverage works, let's assume Company XYZ sold 1,000,000 widgets for $12 each. It has $10,000,000 of fixed costs (equipment, salaried personnel, etc.). It only costs $0.10 per unit to make each widget.

Using this information and the formula above, we can calculate that Company XYZ's operating leverage is:

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%

This means that a 10% increase in revenues should yield a 62.6% increase in operating income (10% * 6.26).

Why it Matters:

In a sense, operating leverage is a means to calculating a company's breakeven point. However, it's also clear from the formula that companies with high operating leverage ratios can essentially make more money from incremental revenues than other companies, because they don't have to increase costs proportionately to make those sales. Accordingly, companies with high operating leverage ratios are poised to reap more benefits from good marketing, economic pickups, or other conditions that tend to boost sales.

Likewise, however, companies with high operating leverage are more vulnerable to declines in revenue, whether caused by macroeconomic events, poor decision-making, etc.

It is important to note that some industries require higher fixed costs than others. This is why comparing operating leverage is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.

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