Operating leverage is a measure of the combination of fixed costs and variable costs in a company’s cost structure. A company with high fixed costs and low variable costs has high operating leverage; a company with low fixed costs and high variable costs has low operating leverage.
A company with high operating leverage depends more on sales volume for profitability – the company must generate high sales volume 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 since variable costs increase proportionately with sales volume.
Operating leverage relates directly to a company’s contribution margin and breakeven point. Contribution margin is essentially a product’s selling price minus its unit-level variable cost. A product with proportionately less variable cost has a higher contribution margin. Hence, a product with a higher contribution margin corresponds with a production process that has high operating leverage – or higher fixed costs in relation to variable costs.
Similarly, a company with a high breakeven point has high operating leverage. The breakeven point refers to the level of sales volume at which per-unit profits fully cover fixed costs of production. In other words, it is the point at which revenues equal costs. Because more fixed costs translate into a higher breakeven point – more sales volume is required to cover the fixed costs – a production process with a high breakeven point utilizes high operating leverage. Of course, when a company with high operating leverage and a high breakeven point reaches sales volumes that exceed the breakeven point, a greater proportion of revenues generating are pure profit.
Degree of Operating Leverage
The degree of operating leverage of a company’s cost structure is a ratio that measure’s the sensitivity of a company’s profits to changes in sales volume. In other words, a company’s degree of operating leverage measures the degree to which a change in sales impacts profitability. In a company with high operating leverage, changes in sales volume magnify changes in profitability. Whereas in a company with low operating leverage the effects of fluctuations in sales volume impact profitability to a smaller degree. A company’s degree of operating leverage can be computed by dividing the percentage change in the operating income by the percentage change in sales volume, as follows:
Degree of Operating Leverage = % Change in Operating Income % Change in Sales Volume