Operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky, or volatile, a company's operating income is.
Definition
There are various measures of operating leverage, which can be interpreted analogously to financial leverage.
Costs
One analogy is "fixed costs + variable costs = total costs..similar to.. debt + equity = assets". This analogy is partly motivated because debt servicing is a fixed cost. This leads to two measures of operating leverage: One measure is fixed costs to total costs: Compare to debt to value, which is Another measure is fixed costs to variable costs: Compare to debt to equity ratio: Both of these measures depend on sales: if the unitvariable cost is constant, then as sales increase, operating leverage decreases.
is a measure of operating leverage: the higher the contribution margin is, the faster the profits increase with sales. Note that unlike other measures of operating leverage, in the linear Cost-Volume-Profit Analysis Model, contribution margin is a fixed quantity, and does not change with Sales. Contribution = Sales - Variable Cost
Operating leverage can also be measured in terms of change in operating income for a given change in sales. The Degree of Operating Leverage can be computed in a number of equivalent ways; one way it is defined as the ratio of the percentage change in Operating Income for a given percentage change in Sales : This can also be computed as Total Contribution Margin over Operating Income: The above equivalence follows as the relative change in operating income with one more unit dX equals the contribution margin divided by operating income while the relative change in sales with one more unit dX equals price divided by revenue. Alternatively, as Contribution Margin Ratio over Operating Margin: For instance, if a company has sales of 1,000,000 units, at price $50, unit variable cost of $10, and fixed costs of $10,000,000, then its unit contribution is $40, its Total Contribution is $40m, and its Operating Income is $30m, so its DOL is This could also be computed as 80%=$40m/$50m Contribution Margin Ratio divided by 60%=$30m/$50m Operating Margin. It currently has Sales of $50m and Operating Income of $30m, so additional Unit Sales yield $5m more Sales and $4m more Operating Income: a 10% increase in Sales and a 10% 13% increase in Operating Income. Assuming the model, for a given level of sales, the DOL is higher the higher fixed costs are : for a given level of sales and profit, a company with higher fixed costs has a lower Operating Income, and hence its Operating Income increases more rapidly with Sales than a company with lower fixed costs. If a company has no fixed costs, then its DOL equals 1: a 10% increase in Sales yields a 10% increase in Operating Income, and its operating margin equals its contribution margin: DOL is highest near the break-even point; in fact, at the break-even point, DOL is undefined, because it is infinite: an increase of 10% in sales, say, increases Operating Income for 0 to some positive number, which is an infinite percentage change; in terms of margins, its Operating Margin is zero, so its DOL is undefined. Similarly, for a very small positive Operating Income, a 10% increase in sales may increase Operating Income to $10, a 100x increase, for a DOL of 990; in terms of margins, its Operating Margin is very small, so its DOL is very large. DOL is closely related to the rate of increase in the operating margin: as sales increase past the break-even point, operating margin rapidly increases from 0%, and as sales increase, asymptotically approaches the contribution margin: thus the rate of change in operating margin decreases, as does the DOL, which asymptotically approaches 1.
Industry-specific
Examples of companies with high operating leverage include companies with high R&D costs, such as pharmaceuticals: it can cost billions to develop a drug, but then pennies to produce it. Hence from a life cycle cost analysis perspective, the ratio of preproduction costs versus incremental production costs is a useful measure of operating leverage.
a product or service is a method used to change the ratio of fixed costs to variable costs in a business. Outsourcing can be used to change the balance of this ratio by offering a move from fixed to variable cost and also by making variable costs more predictable.
