How well does your company use fixed assets to support core business functions? The operating leverage formula may be able to help you find the answers you seek. So, what exactly is operating leverage, and what does the operating leverage ratio indicate for your company? In this article, we define degree of operating leverage, calculate who might use it and why, and demonstrate two methods for calculating operating leverage with the examples and formula.
What Is Operating Leverage?
The degree of operating leverage (DOL), also known as operating leverage, is a financial ratio that measures how well a company uses its fixed costs to generate operating income. DOL expressed as a percentage of total costs reflects how much a company’s operating revenue would increase with an increase in sales. Companies with a higher proportion of fixed costs (the costs of running a business that remains constant over time) than variable costs (the costs that vary in proportion to variations in sales volume and production volume) have higher operating leverage.
Companies generally want to achieve a high DOL in order to increase profitability and find their break-even point—the point at which they make enough sales to cover all of their costs. However, in certain economic conditions, fixed costs that should theoretically lead to higher operating revenue actually reduce a company’s revenue.
What Is the Importance of Operating Leverage?
For a variety of reasons, the degree of operating leverage is an important metric. Evaluating the DOL on a regular basis allows a company to assess its cost structure or current business model, allowing it to make useful changes to increase operating profits. Working backward with the DOL formula can also assist businesses in determining whether they need to increase production or change prices in order to make more money.
A company that has a high degree of operating leverage and high fixed costs will generally not have to increase spending or incur additional costs to increase its sales volume with more business. On a sale-by-sale basis, high operating leverage makes it easier for the company to increase its profit margins or sales revenues.
A low operating leverage company may have a higher proportion of variable assets such as direct materials, inventory, and employee salaries. To increase sales, a company with higher variable costs will typically spend more money on fixed assets, such as direct materials for manufacturing more products.
The Degree of Operating Leverage Formula
There are several methods for calculating the degree of operating leverage. First, we can apply the degree of operating leverage formula from the ratio definition:
% Change in Operating Income / % Change in Sales = Degree of Operating Leverage
We can calculate the operating leverage ratio using the company’s contribution margin because it is closely related to the cost structure. The difference between total sales and total variable costs is the contribution margin.
Contribution Margin/Operating Income = Degree of Operating Leverage
Degree of operating leverage formula
Finally, if we have information about a company’s cost structure, we can apply the following degree of operating leverage formula:
Q(P – V)/Q(P – V) – F = Degree of Operating Leverage
Degree of Operating leverage formula
Where:
- Q – the quantity of units
- P – the unit price.
- V – the variable cost per unit.
- F – for fixed costs.
How to Calculate Operating Leverage
To calculate operating leverage, keep track of the number of units (or products) sold by your company, the price per unit, the variable cost per unit, and the fixed operating costs. Many of these figures can be found on your company’s income statement, cash-flow projections, or other financial statements. Here’s how to calculate your DOL:
- Calculate the earnings before interest and taxes. Subtract the variable cost per unit from the unit price. Then divide this figure by the number of units sold. The end result is your earnings before interest and taxes as a percentage.
- Calculate the percentage increase in sales output. Subtract the variable cost per unit from the unit price. Divide this figure by the number of units sold. Then deduct the fixed operating costs from that figure. This is the percentage change in sales output for you.
- Divide the result to get the operating leverage. Divide the percentage change in sales output calculated in step two by the percentage change in earnings before interest and taxes calculated in step one: This figure represents your degree of operating leverage.
Using a Cost Ratio to Calculate Operating Leverage
If you don’t have access to the company’s financial data, you can still calculate operating leverage with an estimated cost ratio formula:
Operating leverage = % change in income / % change in sales
- Calculate the change in income. Calculate the income change by taking this year’s income and subtracting last year’s income. Divide that figure by the previous year’s income to calculate the percentage change.
- Calculate the change in sales. To calculate the percent change, add this period’s sales to the previous period’s sales and divide by the previous period’s sales.
- Calculate the ratio. To calculate operating leverage, divide the percent change in income by the percent change in sales.
Operating Leverage Examples
Operating leverage appears differently depending on whether it is high or low, as well as the information available for your calculations. Here are three examples to help you understand how to find operating leverage:
Example 1
The following example demonstrates how to apply the cost structure formula to a company with high operating leverage:
An accountant wants to calculate FamilyTime Amusement Park’s operating leverage. They are aware that the fixed costs, which include property taxes, ride operations, and ride maintenance, totaled $200,000. The variable costs per ticket averaged $5. The company sold 10,000 tickets at a cost of $40 each in one year. They can calculate using the cost structure formula because they know all of the cost structure components:
2.3 = 10,000 (40 – 5) / (10,000 (40 – 5) – 20,000
The degree of operating leverage is 2.3. This figure indicates that for every one percent increase in sales, the company’s operating income is expected to increase by 2.3 percent. The accountant or company could compare this figure to other local amusement parks to determine how safe and profitable FamilyTime Amusement is.
Example 2
This example demonstrates how to apply the cost structure formula to a business with low operating leverage:
The owner of Rae’s Restaurant wishes to calculate their operating leverage. They own the property and have low fixed costs. They pay $10,000 in property taxes and utilities for the year. Each meal costs $10 per person served, and the restaurant charges $20 per meal. They sold 100,000 meals this year. They compute the following using the cost structure formula:
1.1 = 100,000 (20 – 10) / 100,000 (20 – 10) – 10,000
The degree of operating leverage is 1.1. This figure indicates that for every one percent increase in sales, the company’s operating income is expected to increase by 1.1 percent. This number is close to one, indicating a safer company with lower potential profits. If data is available, the owner of Rae’s Restaurant could compare this number to other local restaurants or use it to assess their own growth during each period.
Example 3
This example demonstrates how to calculate operating leverage when you don’t have access to a company’s cost structures:
An investor is thinking about purchasing United Logistics stock. They want to calculate operating leverage before investing in order to assess the risk and potential profits of the company.
They locate United Logistic’s balance sheet and discover that net income increased by 20% this year and sales increased by 15%. So, they can use the following cost ratio formula:
20/15 = 1.3
They now understand that the company has an operating leverage of 1.3. This means that for every 1% increase in sales, income is expected to increase by 1.3%. This number can be used by the investor to determine whether or not to invest in the company.
What Does Operating Leverage Indicate?
The operating leverage formula is used to calculate a company’s break-even point and to help set appropriate selling prices that cover all costs while generating a profit. This can reveal how well a company uses fixed-cost assets to generate profits, such as its warehouse and machinery and equipment. The higher a company’s operating leverage, the more profit it can squeeze out of the same amount of fixed assets.
One conclusion that businesses can draw from studying operating leverage is that firms that reduce fixed costs can increase profits without changing the selling price, contribution margin, or number of units sold.
High and Low Operating Leverage:
Because some industries have higher fixed costs than others, it is critical to compare operating leverage between companies in the same industry. The concept of a high or low ratio is then defined more precisely.
The majority of a company’s costs, such as rent, are fixed costs that occur each month regardless of sales volume. Fixed costs are covered and profits are earned as long as a company earns a significant profit on each sale and maintains an adequate sales volume.
Other company costs are variable costs that are incurred only when sales are made. This includes the cost of labor to assemble products as well as the cost of raw materials used to manufacture products. Some businesses earn less profit on each sale, but they can have a lower sales volume and still generate enough revenue to cover fixed costs.
A software company, for example, has higher fixed costs in the form of developer salaries and lower variable costs in the form of software sales. As a result, the company has a high level of operating leverage. A computer consulting firm, on the other hand, charges its clients on an hourly basis and does not require expensive office space because its consultants work in the clients’ offices. As a result, variable consultant wages and low fixed operating costs are achieved. As a result, the company has low operating leverage.
Read Also: OPERATING CYCLE: Definition, Formula, Calculations & Examples
The majority of Microsoft’s costs are fixed, such as those for initial development and marketing. The company makes a profit for every dollar of sales above the break-even point, but Microsoft has high operating leverage.
In contrast, Walmart retail stores have low fixed costs but high variable costs, particularly for merchandise. Because Walmart sells a large number of items and pays in advance for each unit sold, its cost of goods sold rises as sales rise. As a result, Walmart locations have low operating leverage.
How Should You Interpret Operating Leverage?
Operating leverage calculates the fixed costs of a company as a percentage of total costs. As a result, a company with a higher fixed cost will have more leverage than one with a higher variable cost.
Low operating leverage
This implies that fixed costs are lower and variable costs are higher. In this case, a company must achieve minimum sales in order to cover its fixed costs. It can earn money once it reaches the break-even point, where all of its fixed costs are covered.
Once it has reached the break-even point, where all of its fixed costs have been met, it can earn incremental profit in terms of Selling Price minus Variable Cost, which will be small due to the high variable costs.
When operating leverage is low and fixed costs are low, we can safely conclude that the break-even units a company must sell to avoid a no loss & no profit equation will be lower.
High Operational Leverage
This implies lower variable costs while increasing fixed costs. The break-even point will be higher in this case because the fixed costs are higher.
The company must sell a certain number of units in order to avoid a loss and profit situation. The advantage here, on the other hand, is that once the break-even point is reached, the company will earn a higher profit on every product because the variable cost is very low.
Companies generally prefer lower operating leverage so that they can cover fixed costs even if the market is slow.
What Are Some Examples of High and Low Operating Leverage?
Companies with high fixed costs, such as those engaged in extensive R&D and marketing, tend to have high operating leverage. The company makes a profit for every dollar of sales above the break-even point. Retail stores, on the other hand, have low fixed costs and high variable costs, particularly for merchandise. COGS rise as sales rise because retailers sell a large volume of items and pay upfront for each unit sold. As a result, such stores frequently have low operating leverage.
Conclusion
When analyzing a company, we must consider its Operating Leverage. DOL assists us in determining how sensitive its operating income is to changes in Sales. When sales increase, higher DOL will result in a larger change in operating income. However, in the event that sales decline, such companies’ operating income will suffer the most. Companies with a lower DOL, on the other hand, will only see a proportional change in Operating Income.
As an analyst, you should have a thorough understanding of a company’s cost structure, fixed costs, variable costs, and operating leverage. This information is extremely useful when forecasting financials and creating a financial model in Excel.
Operating Leverage FAQs
What is a high DOL?
A high DOL indicates that the firm’s fixed costs outnumber its variable costs. It suggests that the company can increase its operating income by increasing sales. Furthermore, the company must maintain relatively high sales in order to cover all fixed costs.
What if operating leverage is negative?
Negative leverage suggests that the company is not earning enough revenue to pay costs or that the contribution margin is less than the total fixed cost.
Which industries have high operating leverage?
Retailers and labor-intensive industries such as restaurants and accounting companies have low operating leverage, while tech companies, utilities, and airlines have high operating leverage.
