Operating Leverage: Formula & Examples
Operating leverage measures a company’s ability to increase its operating income by increasing its sales volume.
What is Operating Leverage?
Operating leverage measures a company’s ability to increase its operating income by increasing its sales volume. As a cost accounting measure, it is used to analyze the proportion of a company's fixed versus variable costs. A thorough understanding of operating leverage can help to set sales prices appropriately to ensure total costs are covered and the company can meet its breakeven point– the point at which its total costs and total revenues are the same.
What are Fixed Costs?
Fixed costs are constant expenses that the company incurs whether or not it sells any goods or services. It is not affected by sales or production volume. Rather, it is usually an expense that is time dependent. Examples of fixed costs include:
- Rent or loan payments
- Phone or internet bills
- Salary expense
What are Variable Costs?
Variable costs do exactly as the name implies– they vary based on sales or production volume. If a company ramps up its output of goods or services, its variable costs will increase. Examples of variable costs include:
- Hourly labor expense
- Sales commissions
- Shipping and distribution expenses
The sum of all fixed and variable costs is referred to as total cost.
What is the Degree of Operating Leverage?
The degree of operating leverage is a formula that measures the impact on operating income based on a change in sales. It is considered to be high when operating income increases significantly based on a change in sales. It is considered to be low when a change in sales has little impact– or a negative impact– on operating income.
Degree of Operating Leverage Formula
There are a couple ways to calculate the degree of operating leverage. The first option is:
Degree of Operating Leverage = % Change in Operating Income / % Change in Sales Revenue
In this formula, the percentage change is calculated year-over-year. You can calculate the percentage increase or decrease by dividing the second year’s number by the first year’s number and subtracting 1.
This formula is useful because you do not need in-depth knowledge of a company’s cost accounting, such as their fixed costs or variable costs per unit. This level of detail is not given on a standard financial statement. From an outside investor’s perspective, this is the easier formula for degree of operating leverage.
The second option is:
Degree of Operating Leverage = Contribution Margin / Profit
Where:
- Contribution Margin = Unit Quantity x Unit Contribution Margin (Unit Sales Price - Variable Costs per Unit)
- Profit = Unit Quantity x Unit Contribution Margin - Fixed Costs
This formula can be used by managerial or cost accountants within a company to determine the appropriate selling price for goods and services. If used effectively, it can ensure the company first breaks even on its sales and then generates a profit.
Operating Leverage Example
As the cost accountant in charge of setting product pricing, you are analyzing ABC Company’s fixed and variable costs and want to look at the degree of operating leverage. ABC sells 500,000 units of its primary product at a sales price of $25. Its variable costs per unit are $15, and ABC’s fixed costs are $3,000,000.
Using this information, you can calculate the degree of operating leverage using the formula:
(500,000 units x $10) / [(500,000 units x $10) - $3,000,000] = 2.5
Where:
- 500,000 = units of the product produced
- $10 = $25 sales price - $15 variable cost per unit = contribution margin per unit
- $3,000,000 = fixed costs
This tells you that, for a 10% increase in sales volume, ABC will experience a 25% increase in operating profit (10% x 2.5). The current sales price and sales volume is also sufficient for both covering ABC’s $3,000,000 fixed costs and turning a profit as a result of the $10 per unit contribution margin.
Real Company Example: Operating Leverage
Walmart’s income statement is available in its 2023 Annual Report. It shows $611.289 billion in 2023 revenues and $527.754 billion in 2022 revenues. For operating income, Walmart shows $20.428 billion in 2023 and $25.942 in 2022.
Using the simplified degree of operating leverage formula:
[($611.289 / $527.754) - 1] / [($20.428 / $25.942) - 1] = 0.158 / -0.213 = -0.742
Where:
- ($611.289 / $527.754) - 1 = 0.158 = % change in year-over-year revenue
- ($20.428 / $25.942) - 1 = -0.213 = % change in year-over-year operating income
Although revenues increase year-over-year, operating income decreases, so the degree of operating leverage is negative. This means that for a 10% increase in revenue, there was a corresponding 7.42% decrease in operating income (10% x -0.742).
What is a Good Operating Leverage?
What is considered a good operating leverage depends highly on the industry. A higher operating leverage means the company has higher fixed costs, and a lower operating leverage means the company has higher variable costs. After its breakeven point, a company with higher operating leverage will have a larger increase to its operating income per dollar of sale.
Typically, a higher operating leverage is considered to be better. However, a lower operating leverage is not necessarily bad. It just means the company has a higher proportion of variable costs.
High Operating Leverage Industries
Certain industries are high operating leverage industries. Mining, utilities, and airline industries are some examples of high operating leverage industries. These industries have a higher proportion of fixed costs– such as major equipment purchases and salary expenses– and lower costs associated with a specific sale.
For example, mining businesses have the up-front expense of highly specialized equipment. Airlines have the expense of purchasing and maintaining their fleet of airplanes. Once they have covered their fixed costs, they have the ability to increase their operating income considerably with higher sales output. An extra ticket on a flight does not add a huge cost to the airline. On the other hand, low sales will not allow them to cover their fixed costs.
Low Operating Leverage Industries
Low operating leverage industries include restaurant and retail industries. These industries have higher raw material costs and lower comparative fixed costs. For example, for a retailer to sell more shirts, it must first purchase more inventory. When a restaurant sells more food, it must first purchase more ingredients. The cost of goods sold for each individual sale is higher in proportion to the total sale. For these industries, an extra sale beyond the breakeven point will not add to its operating income as quickly as those in the high operating leverage industry.
What is the Difference Between Operating Leverage and Financial Leverage?
Operating leverage and financial leverage are two types of financial metrics that investors can use to analyze a company’s financial well-being. Financial leverage relates to the use of debt financing to fund a company’s operations. Debt financing appears on the company’s balance sheet. A company with a high financial leverage will need to have sufficiently high profits in order to pay off its debt obligations.
Operating leverage is used to determine the breakeven point based on a company’s mix of fixed and variable to total costs. Operating leverage uses figures only from the income statement.
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