Operating Leverage: What It Is, How It Works, How To Calculate

When it comes to the world of business and finance, the concept of Leverage is one that is often misunderstood. When we think about Leverage, the majority of the time, we are either thinking of the amount of debt that is shown on a balance sheet or the practice of using borrowed funds for investing reasons. But what we don't recognize is that Leverage also has a positive connotation; it demonstrates the level to which you can utilize Leverage as the fulcrum to drive additional growth for the firm. In order to do this, you need to have an understanding of what operating Leverage is as well as how to use operating Leverage. When we discuss Leverage, there are two sides to every coin. There is financial Leverage, and there is also operational Leverage. In this article, we are placing more emphasis on the idea of operating Leverage, and we are going to learn how to calculate operating leverage.

What is Operating Leverage?

The relationship between a firm's operations, its revenue from operations, and the profitability that the company obtains from those activities is known as operating Leverage. The operating leverage formula is used to determine the point at which a business will be profitable as well as to assist in the establishment of proper selling prices to ensure that all expenditures are covered while still generating a profit. This may show how well a business is generating money from its fixed costs, such as its warehouse and machinery, and equipment. The more a company's ability to increase its profit while maintaining the same level of fixed assets is, the higher the company's operating Leverage will be.

One of the conclusions that can be drawn from an analysis of operating Leverage is that businesses that minimize their fixed costs have the ability to increase their profits without altering the selling price, contribution margin, or the number of units that they sell.

Important Terms

Fixed Cost

A fixed cost is the cost of an expenditure incurred by a firm that does not fluctuate, regardless of whether the number of products and services produced increases or decreases. Because they occur on a consistent basis regardless of the number of goods or services sold, fixed costs are sometimes referred to as recurring expenses, Rent, insurance premiums, interest payments on loans, and electricity bills are typical examples of fixed costs. It makes no difference to these expenditures whether a company has one customer or one hundred customers; they still have to make their monthly payments on their loans and rent regardless of the number of consumers they have.

Variable Cost

A variable cost is a kind of business expenditure that varies from one period to the next depending on the volume of goods or services produced or sold by the company. When the volume of a firm's production or sales changes, the variable costs of that company also change. Variable costs go up when the amount of production goes up, and they go down when the volume of production goes down. Raw material and packaging expenses are two types of variable costs that might be incurred by a manufacturing organization.

Contribution Margin

Contribution margin, often known as gross margin, is the amount of revenue remaining after all variable costs associated with manufacturing a product have been deducted. When your contribution margin is subtracted from fixed expenditures like rent, equipment leases, and wages, the result is your net income, often known as your profit.

Company with High Operating Leverage

When an organization has a high level of operating Leverage, a significant amount of the company's expenses are composed of fixed costs. In this scenario, the company makes a significant profit off of every additional sale that it makes, but it still has to achieve a certain level of sales volume in order to pay its substantial fixed costs(Break-even point). If it is successful in doing so, the organization will be able to generate a massive profit after deducting its fixed costs from the total amount of money it brings in through sales. However, the impact of fluctuations in sales volume on profitability will be greater.

Examples: Telecommunications (Hardware), Airlines & Leisure, Energy / Oil & Gas, Pharmaceuticals

Company with Low Operating Leverage

Due to the high proportion of variable costs in a low operating leverage scenario, the corporation only pays these expenses when there is a sale. In this scenario, the company makes a lesser profit on each incremental sale, but it does not need to create very much more sales volume in order to pay its lower fixed costs. This is because the fixed costs are lower. When sales are low, it is simpler for a firm of this sort to turn a profit; nevertheless, even when sales are increased, the company does not see a significant increase in its profit margin.

In general, businesses seek to have lower operating Leverage so that even in circumstances in which the market is slow, it will not be difficult for them to pay the fixed costs that they have.

Examples: Professional Services (Consulting, Legal, etc.), Retailers, E-Commerce, Restaurants, and Food Services

How to Determine the Organization's Level of Operating Leverage

In order to calculate operating Leverage, you must first determine the number of units (or goods) that your firm is selling, in addition to the price per unit, the variable cost per unit, and the fixed operating costs. You should be able to locate most of these figures on the income statement, cash-flow statements, or one of the other financial statements that a firm maintains. The following is the formula that should be used to determine your operating Leverage:

1. Determine the profits prior to the deduction of interest and taxes(EBIT). In the first step of the calculation, take the price per unit and remove the variable cost per unit. The next step is to multiply this total by the number of items that were actually sold. After that, deduct from that total the amount that is dedicated to fixed operating costs. This gives you a proportion of your earnings before interest and taxes.
2. Determine the percentage shift in the number of sales that were made.
3. Perform the division in order to establish the operating Leverage. Divide the percentage of profits before interest and taxes that you determined in step one by the percentage of change in sales output that you calculated in step two: This value represents the operational Leverage that the company has.

An Example of the Operating Leverage Calculation

The following is a list of the Mit-Mat Cookie Company's financial results:

Revenues: $100,000

Variable expenses: $30,000

Fixed expenses: $60,000

$10,000 net operating income

The Mit-Mat Cookie Company has a contribution margin of 70 percent and a net operating income of ten thousand dollars, which provides it with a degree of operating Leverage of seven. The subsequent rise in sales at the Mit-Mat Cookie Company of twenty percent that occurs as a direct consequence of the appearance of a segment on a local television program is reflected in the following financial outcomes:

Revenues: $120,000

Variable expenses: $36,000

Fixed expenses: $60,000

$24,000 net operating income

The contribution margin of 70% has remained the same, and the company's fixed costs have remained the same as well. Because the Mit-Mat Cookie Company has a lot of operating Leverage, the 20% increase in sales leads to a net operating income that is more than double what it was before.

One more thing to keep in mind is that the results of any specific calculation of operating Leverage are only applicable for a certain range of increased sales. This is due to the fact that almost no fixed costs are maintained at a constant level, regardless of the level of sales. Intuitively, one could not reasonably assume that sales of a product to quadruple without requiring some major rise in fixed costs, such as the amount of warehouse space required, the number of administrative staff members required, and other such expenses.

Conclusion

In the world of business, having knowledge about the level of operating Leverage that a firm has may have a major influence on the pricing structure. This is because a company that has a large amount of operating Leverage must be cautious not to set its prices too low so that it can never create enough contribution margin to completely offset its fixed expenses.