Operating Leverage

Operating Leverage

See Also:
Homemade Leverage
Valuation Methods
Financial Ratios
Operating Profit Margin Ratio
Operating Cycle
What Your Banker Wants You to Know

Operating Leverage Definition

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; whereas a company with low fixed costs and high variable costs has low operating leverage.

High and 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.

Contribution Margin and Breakeven Point

This term 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.


Cash is king, so how are you improving your company’s cash flow?

[button link=”https://strategiccfo.com/25-ways-to-improve-cash-flow/” bg_color=”#eb6500″]Download The 25 Ways to Improve Cash Flow[/button]


Degree of Operating Leverage

The degree of leverage of a company’s cost structure is a ratio that measure’s the sensitivity of profits to changes in sales volume. In other words, this measures the degree to which a change in sales impacts profitability. In a company with high leverage, changes in sales volume magnify changes in profitability. Whereas in a company with low leverage the effects of fluctuations in sales volume impact profitability to a smaller degree. Divide the percentage change in the operating income by the percentage change in sales volume to find the degree of operating leverage. Use the following formula:

Degree of Operating Leverage = % Change in Operating Income ÷ % Change in Sales Volume

For more tips on how to improve cash flow, click here to access our 25 Ways to Improve Cash Flow whitepaper.

Operating Leverage
[box]Strategic CFO Lab Member Extra
Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

Click here to access your Execution Plan. Not a Lab Member?
Click here to learn more about SCFO Labs[/box]

Operating Leverage

ARTICLES YOU MIGHT LIKE

IN CRISIS? GET A STRATEGIC CFO! – CEO Blindspots Podcast

Friend of the firm, Birgit Kamps, recently had Strategic CFO President, Dan Corredor, as a guest on her podcast, CEO Blindspots. CEO BLINDSPOTS HOST: Birgit Kamps. She was speaking five languages by the age of 10, and lived in five countries with her Dutch parents prior to becoming an American citizen. Birgit’s professional experience includes starting

Read More »

SHRM calls ICHRA the 401K for Group Health Benefits

Fed-up with group health insurance? ICHRA is the new way to offer great health benefits and avoid ACA penalties, SHRM calls it the 401K for group health benefits.  In 2020 the Department of Labor, HHS and IRS changed the rules for employer health benefits. They changed the Affordable Care Act mandates and penalties for every

Read More »

Financial Ratios

See also:Quick Ratio AnalysisPrice to Book Value AnalysisPrice Earnings Growth Ratio AnalysisTime Interest Earned Ratio Analysis Use of Financial Ratios Financial Ratios are used to measure financial performance against standards. Analysts compare financial ratios to industry averages (benchmarking), industry standards or rules of thumbs and against internal trends (trends analysis). The most useful comparison when

Read More »

JOIN OUR NEXT SERIES

Financial Leadership Workshop

MARCH 28TH-31ST 2022

SHARE THIS ARTICLE

JOIN THE NEXT STRATEGIC CFO™ SERIES

Strategic CFO™ Financial Leadership Workshop
The Art of the CFO®

Days
Hours
Min
Sec

June 13th - 16th 2022