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

What Is Operating Leverage?

Operating leverage is a cost-accounting formula (a financial ratio) that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage.

Understanding Operating Leverage

The higher the degree of operating leverage, the greater the potential danger from forecasting risk, in which a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.

The Operating Leverage Formula Is:

$\text{Degree of operating leverage} = \frac{\text{Contribution margin}}{\text{Profit}}$Degree of operating leverage=ProfitContribution margin​

This can be restated as: 

$\begin{aligned} &\text{Degree of operating leverage} = \frac{Q*CM}{Q*CM - \text{Fixed operating costs}}\\ &\textbf{where:}\\ &Q = \text{unit quantity}\\ &CM = \text{contribution margin (price - variable cost per unit)}\\ \end{aligned}$​Degree of operating leverage=Q∗CM−Fixed operating costsQ∗CM​where:Q=unit quantityCM=contribution margin (price - variable cost per unit)​

The operating leverage formula is used to calculate a company’s break-even point and help set appropriate selling prices to cover all costs and generate a profit. The formula can reveal how well a company uses its fixed-cost items, such as its warehouse, machinery, and equipment, to generate profits. The more profit a company can squeeze out of the same amount of fixed assets, the higher its operating leverage.

One conclusion companies can learn from examining operating leverage is that firms that minimize fixed costs can increase their profits without making any changes to the selling price, contribution margin, or the number of units they sell.

Example Of Operating Leverage

For example, Company A sells 500,000 products for a unit price of $6 each. The company’s fixed costs are $800,000. It costs $0.05 in variable costs per unit to make each product.

Calculate company A’s degree of operating leverage as follows:

$\begin{aligned} &\frac{500,000*\left(\$6.00 - \$0.05 \right )}{500,000*\left(\$6.00 - \$0.05 \right )-\$800,000}\\ &=\frac{\$2,975,000}{\$2,175,000}\\ &=1.37 \text{ or } 137\%. \end{aligned}$​500,000∗($6.00−$0.05)−$800,000500,000∗($6.00−$0.05)​=$2,175,000$2,975,000​=1.37 or 137%.​

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

High and Low Operating Leverage

It is important to compare operating leverage between companies in the same industry, as some industries have higher fixed costs than others. The concept of a high or low ratio is then more clearly defined.

Most of a company’s costs are fixed costs that recur each month, such as rent, regardless of sales volume. As long as a business earns a substantial profit on each sale and sustains adequate sales volume, fixed costs are covered, and profits are earned.

Other company costs are variable costs that are only incurred when sales occur. This includes labor to assemble products and the cost of raw materials used to make products. Some companies earn less profit on each sale but can have a lower sales volume and still generate enough to cover fixed costs.

For example, a software business has greater fixed costs in developers' salaries and lower variable costs in software sales. As such, the company has high operating leverage. In contrast, a computer consulting firm charges its clients hourly and doesn't need expensive office space because its consultants work in clients' offices. This results in variable consultant wages and low fixed operating costs. The business thus has low operating leverage.

Most of Microsoft's costs are fixed, such as expenses for upfront development and marketing. With each dollar in sales earned beyond the break-even point, the company makes a profit, but Microsoft has high operating leverage.

Conversely, Walmart retail stores have low fixed costs and large variable costs, especially for merchandise. Because Walmart sells a huge volume of items and pays upfront for each unit it sells, its cost of goods sold increases as sales increase. Because of this, Walmart stores have low operating leverage.

The Bottom Line

Operating leverage is the ratio of a business's fixed costs to its variable costs. This ratio is often used when forecasting sales and determining appropriate prices.