What is operating leverage?

Definition of operating leverage 

In the long run, all costs are variable. But in the short run (e.g., business cycle), some costs are fixed: these costs can have a leverage effect on operating income.

So what is operating leverage?

Operating leverage is how a company's net income reacts to the changes in sales volume. Operating leverage reflects the relationship between variable and fixed costs in a company’s cost structure.

Operating leverage essentially measures the proportion of fixed costs in a company’s cost structure and how a change in sales volume affects the company’s profit. In other words, operating leverage affects profit stability.

Company’s cost structure (i.e., a relative proportion of fixed and variable costs) depends on many factors, including long-run trend in sales, sales fluctuations, management’s attitude towards risk, etc. Companies in the same industry can have different cost structures and thus different operating leverages.

Companies with high operating leverage have the following cost structure:

• High fixed costs*
• Low variable costs

Companies with low operating leverage have an opposite cost structure:

• Low fixed costs*
• High variable costs

(*) Important to note, fixed costs are high or low in relation to variable costs.

So why does it matter if operating leverage is high or low?

When operating leverage is high, a change in sales results in a large change in profit (loss). On the other hand, when operating leverage is low, a change in sales results in a small change in profit (loss).

Key points about operating leverage are summarized in the table below:

	High Operating Leverage	Low Operating Leverage
Fixed costs	High	Low
Variable costs	Low	High
Profit stability (when sales fluctuate)	Lower	Greater
Good years (↑ sales)	Greater profits	Lower profits
Bad years (↓ sales)	Greater losses	Lower losses
Contribution margin	Higher	Lower
Break-even point	Higher	Lower
Margin of safety	Lower	Higher

As we can see from the table above, operating leverage is important for cost-volume-profit considerations.

Operating leverage analysis 

Let’s look at a simple example. Let’s assume that HOL Company and LOL Company (i.e., fictitious entities) have the same level of sales and the same net operating income but different fixed and variable costs. HOL Company has a high operating leverage while LOL Company has a low operating leverage. We have the following information about the companies:

	HOL Company		LOL Company
	Amount	%	Amount	%
Sales	$100,000	100	$100,000	100
Variable expenses	(25,000)	25	(70,000)	70
Contribution margin	75,000	75	30,000	30
Fixed expenses	(60,000)		(15,000)
Net operating income	$15,000		$15,000

To compare operating leverage across companies, we can use the following ratios (non-exhaustive list):

• Degree of operating leverage: contribution margin divided by net income
• Contribution margin ratio: contribution margin divided by sales
• Break-even point (in dollars): fixed costs divided by contribution margin ratio
• Margin of safety: the different between actual and break-even sales divided by actual sales

Based on the companies’ cost structure and operating leverage, we would expect the following results for HOL Company and LOL Company:

	HOL Company	LOL Company
Degree of operating leverage	High	Low
Contribution margin ratio	High	Low
Break-even point (in dollars)	High	Low
Margin of safety	Low	High