Operating Leverage: Features, Advantages, Example

The operating leverage is the degree to which a company or project can increase its operating income to the increase profits. A company that generates sales with a high gross margin and low variable costs has high operating leverage.

The higher the degree of operating leverage, the greater the potential hazard of the risk forecast, where a relatively small error in the sales forecast can be expanded to large errors in the cash flow projections.

Operating leverage can be used to calculate a company's breakeven point and substantially affect earnings by changing its pricing structure.

Because companies with higher operating leverage do not increase expenses commensurately as sales increase, those companies can generate more operating income than other companies.

However, companies with a high level of operating leverage are also more affected by poor corporate decisions and other factors that can cause a decline in revenue.

Operating leverage is an indicator of the combination of fixed costs and variable costs in a company's cost structure.

High and low operating leverage
It is key to compare operating leverage between companies in the same industry. This is because some industries have higher fixed costs than others.

A company with high fixed costs and low variable costs has high operating leverage. On the other hand, a company with low fixed costs and high variable costs has low operating leverage.

A company with high operating leverage is more reliant on sales volume for profitability. The company must generate a high volume of sales to cover the high fixed costs. In other words, as sales increase, the company becomes more profitable.

In a company with a cost structure that has low operating leverage, increasing sales volume will not dramatically improve profitability, as variable costs increase proportionally with sales volume.

Fixed and variable costs
Most of a company's costs are fixed costs, which occur regardless of sales volume.

As long as a business makes a substantial profit on each sale and maintains adequate sales volume, fixed costs will be covered and profits will be made.

Other company costs are variable costs incurred when sales occur. The business makes less profit for each sale, but needs a lower sales volume to cover fixed costs.

Degree of operating leverage
The formula for the degree of operating leverage is:

Degree of operating leverage =

% change in net operating profit /% change in sales =

Contribution margin / Net operating profit.

This formula breaks down as follows:

Contribution margin = Quantity x (Variable Price-Cost per unit)

Net operating profit = [Quantity x (Price-Variable cost per unit) -Fixed operating cost]

Advantages and disadvantages
Operating leverage can tell managers, investors, creditors, and analysts how risky a company can be.

Although a high degree of operating leverage can be beneficial to the business, companies with a high degree of operating leverage can often be vulnerable to the business cycle and changing macroeconomic conditions.

When the economy is booming, a high degree of operating leverage can increase a company's profitability.

However, companies that need to spend a large amount of money on property, plant and machinery cannot easily control consumer demand.

So in the event of an economic slowdown, your profits may plummet due to your high fixed costs and low sales.

Companies with high operating leverage are more vulnerable to declining revenues, whether due to macroeconomic events, poor decision making, etc.

Comparisons and check
Some industries require higher fixed costs than others. This is the reason why the comparison of operating leverage is more significant between companies within the same industry. The definition of a high or low grade must be done within this context.

When using the operating leverage indicator, its constant check on a company with high operating leverage is more important, as a small percentage change in sales can lead to a dramatic increase or decrease in profit.

A company must take special care when forecasting its revenue in these situations, as a small forecast error translates into much larger errors in both net income and cash flows.

Pricing policy
A company with high operating leverage must be careful not to set prices so low that it can never generate enough contribution margin to fully cover its fixed costs.

Operating leverage is directly related to a company's breakeven point. A company with a high breakeven point has a high level of operating leverage.

The breakeven point refers to the level of sales volume where the profit per unit fully covers the fixed costs of production. In other words, it is the point where income equals costs.

Because high fixed costs translate to a higher breakeven point, higher sales volume is required to cover fixed costs. A production process with a high breakeven point uses high operating leverage.

Company A sells 500,000 products annually for $ 6 each. The company's fixed costs are $ 800,000. Each product costs $ 0.05 in variable cost per unit to make. Company A's degree of operating leverage is:

500,000 x ($ 6- $ 0.05) / [500,000 x ($ 6- $ 0.05) - $ 800,000] = $ 2,975,000 / $ 2,175,000 = 1.37 or 137%.

Therefore, a 10% increase in revenue should result in a 13.7% increase in operating income (10% x 1.37 = 13.7%).

Real companies
Most of Microsoft's costs are fixed, such as initial development and marketing expenses. With every dollar in sales revenue earned beyond breakeven, the business makes a profit. Therefore, Microsoft has a high level of operating leverage.

In contrast, Walmart retail stores have low fixed costs and large variable costs, especially for merchandise.

Because Walmart stores pay for the items it sells, the cost of merchandise sold increases as sales increase. Therefore, Walmart stores have a low level of operating leverage.

see also finance and business knowledge

Annuities Meaning

Finding Travel Insurance For Cancer Diagnosis

How Does the Stock Market Work

Top 10 Ways to Make Money Online

10 Legit Ways to Make Money and Passive Income Online

10 Ways To Cut Your Health Care Costs

The Ultimate Assurance of Buy-sell Agreements

5 Tips to Prepare for Your Property Settlement

8 Habits of Wealthy and Successful People

Why Millennials Choose to Buy Home

7 Tips Every Homeowner Need to Know About Insurance

8 Tip on Homeownner Insurance

10 Question You Should Ask Mortgage Lenders

How Much is My Car Accident Settlement Worth

200 Business Movement News

150 Financial Tip You Should Know

Essential List of Mortgage Application Document

Prepare Yourself Before Investing in Stock

Shopping is the Right Way Without Debt

Factors Affecting Home Loan Rates

Using Credit Cards With No Debt

Plan for Business Loans

Step Before Buying Insurance

Choosing Life Insurance

How to Get Cheap Car Insurance

If in Debt With a Credit Card

Type of Insurance

How to Request a Claim

Deposit With Banks or Take Out Insurance

Why Do We Need Life Insurance

Insure Assets and Liabilities How is It Different

Contract for Buying a House

Happy if in Debt

Can Not Pay the Car Installments

16 Most Important Car Insurance Terms

Want to Use Urgent Money Where Should I Request a Loan

Save Money in Stocks

How to Have a Home

Plan Before Retirement

Plan for Repayment Carefully

50 Financial Movement You Should Know

How You Can Hit the Heights While Plunging to the Depths

10 Ways to Cut Your Health Care Costs

Tips for Handling an Employee's Departure

How to Get Your Product Onto Retailers' Shelves

A List of Pointers for Low-cost Promotion

A Field Guide to Office Colleagues

How to Get Your Tqm Training on Track

4 Excuses to Use Unconscious Credit Cards

Be Careful Terms of Insurance Agreement

Changing a Home to Pay Off Debt

Want Money to Invest

Credit Card Addiction Symptoms

How to Manage Credit Card Debt if Lose Job

What is Private Fund

Loans for Education

10 Things That Lead to Poverty

Do Not Overlook Insurance

There Are Also Saving on Debt

10 Things You Need to Do Before Retiring

Seed Funds for the Smallest Start-ups

Health Insurance Managed Care Can Cost More

States Go for Bold Changes

Outside Directors: How They Help You

Helping Your Children Plan for a Distant Future

The Tax Advantages of a Home Office

Job Skills Have Declined Firms Say

American Get More for Their Money

Boost Your Problem-solving Power

Finding the Essence of Good Sales People

Suggestions on Selling Your Service Firm

Warming to the Idea of Customer Feedback

It's Timely to Consider Still Another Inequality

More Tax Cuts Coming

Vice Presiddency Becoming More Attractive Goal

Turn Anger Into an Asset

Making the Most of Trade Shows

Ideas for Making the Most of Time on the Road

The Benefits of Smart Inventory Management

Policies That Protect a Company's Good Name

Market-neutral Funds May Offer Solace if Stocks Tank

Bargains in Business Insurance

Bills Would Affect the Hiring of Skilled Foreign Workers

The Ups and Downs of a Postal Rate Proposal

Locking on to Teamwork

Nurturing Part Timers to Be Entrepreneurs

Holding Things Together When Selling A Location

Knowing When Cut The Cord

A New Selling Approach Makes Fashion Sense

Too Much Team Harmony Can Signal Trouble

Oiling The Wheels Of Consumer Satisfaction

Networking 101: Seeing And Being Seen

Nuts About Snack Food

A Jet-Powered Takeoff

Grooming For Success

Switching to Self Insurance

Promoting A World Ethical Standard

Help Wanted Desperately

How to Get a Yes From Your Banker

Lawmakers Have Their Work Cut Out For Them

Making The Climb Onto Store Shelves

Hammering Home Performance Incentives

Have You Seen Your Banker For Your Annual Checkup

Protect Your Company's Proprietary Information

Adding Some Byte To Retirement Plans

From The Ground Up

Pluses And Pitfalls In Voice Mail

Lawmakers Have Their Work Cut Out For Them

Making The Climb Onto Store Shelves

Market Bulls Battle A Case Of Nerves

Check The Fine Print In Picking A 401 (k) Plan

5 Pitfalls Make Your Work Inefficient

Wrong Stock Investing

What is a non life insurance

5 things to do if you want to succeed

5 steps Emphasize the use of credit cards correctly

Unemployment can be saved by doing 5 steps

Obstacles that prevent from saving

Want to be rich do these 3 things

New to the stock market

Change the attitude of saving with 3 steps

Home loan Not difficult anymore

Start investing is not difficult

Come check the finance health

Live 3 items for solving the poor

5 wrong financial views Risking destruction

4 things that should not be overlooked for Save money

Wise financial planning techniques for the family

5 mistakes checklist when buying insurance

5 reduce the risk of doing business

3 risk levels that must be known before investing

Advantages and disadvantages of Requesting a loan

Saving The US Economy

What price loyalty at Vodafone

Alphabet soup and economic recovery

Our growing nostalgia for commuting

Financial alchemy

Personal credit

4 principles of financial success

Buying housing is not a big deal anymore

Essential insurance

How to teach your child to be wise With the use of money

6 Collection techniques That a salary man needs to do

How to choose a credit card that best suits your needs

Beware The Scammers out to empty your bank account

Avoid The Traps Set By Estate Agents

10 Ways To Cut Your Health Care Costs

What is the stock market

Adjust the idea of adding value to your business

How ready are you for down

10 techniques to use money

10 Ideas To Conquer Stocks

10 Year Retirement Plan

Factors That Make Your Finances Worse

Eliminate 5 Weaknesses to Create Success in SME

Retirement Investment Plan Longevity Simpler

5 Secrets to Financial Freedom

How to Invest Without Losing

Do We Need Too Much Money

8 Alarms When Finances Are in Trouble

How to Use Money Saving Techniques

Credit Card Debts Not Difficult Anymore

Long Term Savings

Financial Matters Young People Should Know

The 5 Phases of Money Flow

Youth Fever for Cryptocurrencies

Economy Versus Demagoguery

Resistance to Organizational Change

What is Production budget

What are the Goods in Commission

What are Returns on Purchases

What are Pre Operating Expenses

What is a Technical Organization

10 Types of Credit Securities

5 Main Types of Business Organization

What Is a Business Advisor

What is the Personification of Accounts

What Is Expense policy

6 Stages of Administrative Organization

Social Responsibility of Institutions

What Is Business Environment

Forms of Organization of Economic Entities

Top 9 Functions of a Salesperson

7 Duties of an Accounting Clerk

7 Most Outstanding Comptroller Functions

What Is Bookkeeping

What Are Taxes Payable

Armand Feigenbaum Biography

What Is Zero Base Budgeting

What Is Chart of Accounts

What Is Sensitivity Analysis

What Is Purchasing Department

Origin of Business Management

What Is Administrative Organization

What is Cost Accounting

What Is Organizational Structure

What Is Nominal Salary

What Is Centralization In Administration

What Is Payable Documents

What Is Indirect Labor

What Is Going Business

What Is Commercial Paper

What Is Delivery In Business

What Is Equivalent Units

What Is Income Centers

Search This Blog

Popular Posts