Operating leverage refers to relative amount of costs that are fixed and variable in the cost structure of a business.
High Operating Leverage
Some companies will have relatively high fixed costs compared with variable costs and are said to have a high operating leverage. For example, pharmaceutical companies incur costs of up to $1 billion to develop new drugs over a 10 to 15 year period, whereas the manufacture costs just pennies – just think of the price of a pack of paracetamol in your local pharmacy.
Low Operating Leverage
Low operating leverage means variable costs are a relatively high proportion of total costs. Retailers like US-based Tesco or Sainsbury have relatively low fixed costs and relatively high variable costs – the variable cost of each item sold (for example, the purchase price) is likely to be much higher than the associated fixed cost for that item.
The degree of operating leverage of a company can be used to assess its risk profile. Companies with high operating leverage are more vulnerable to decreasing sales, for example sharp economic and business cycle swings. Companies with a high level of costs tied up in machinery, plant and equipment cannot easily cut costs to adjust to a change in demand. So, if there is a downturn in the economy revenues and profits can plummet.
On the other hand, companies with lower operating leverage can adapt their cost structure more rapidly as they have more variable costs.
Degree of Operating Leverage
The degree of operating leverage can be measured by taking the contribution in proportion to profit as follows (remember that contribution is sale minus variable costs):
\[\text{Degreeof of Operating Leverage=}\frac{\text{Contribution}}{\text{Profit}}\]
Example
Assume a software company has invested 10 million dollars into developing and marketing an application, which sells for 45 dollars per copy. Each copy costs the company 5 dollars to sell. Sales volume is expected to reach 1 million copies. The degree of operating leverage can be calculated as follows:
\[\frac{1,000,000\times \left( 45-5 \right)}{1,000,000\times \left( 45-5 \right)-10,000,000}=\frac{40,000,000}{30,000,000}=1.33\]
Thus, the degree of operating leverage is 1.33. This means that, for example, a 25 percent increase in sales volume would produce a 33 per cent (25% × 1.33) increase in profits – here are the figures to prove this:
| Million $ | |
| Sales (1.25 m * $45) | 56.25 |
| Variable Cost (1.25 m * $5) | 6.25 |
| 50 | |
| Fixed Cost | 10 |
| Profit | 40 |
Conversely, if sales in the above example decreased by 25 percent, profits would decline by 33 percent.
What the operating leverage of a business teaches is that you should always be conscious of the risks associated with any changes in cost structure.
Some sectors have high or low operating leverage. Nonetheless, having an appreciation of the degree of operating leverage assists managers in judging the effects of changes to the relative proportion of fixed and variable costs.