Based on this information the magnitude of operating leverage is approximately

Operating leverage relates to a company’s fixed vs. variable costs – a company with a higher percentage of fixed costs is said to have “high operating leverage,” because as its sales grow, more of those sales trickle down into operating income.

For example, software companies tend to have high operating leverage because most of their spending happens upfront in the product development process.

Selling each additional copy of a software product costs very little since the distribution is almost free and there are no “raw materials.”

On the other hand, consulting or services companies have low operating leverage because most of their spending is variable: as sales increase, their spending increases in lockstep, and as sales decrease, their spending also decreases.

So the end result is that operating leverage introduces higher potential rewards, but also greater risk.

If a company’s sales increase, it helps to have higher operating leverage. But if they decrease, higher operating leverage hurts them because they won’t be able to reduce spending as quickly.

Operating Leverage Formula Examples

There are several different formulas for calculating operating leverage:

Operating Leverage Formula 1: Fixed Costs / (Fixed Costs + Variable Costs)

The problem with this one is that most companies don’t spell out what is a fixed vs. variable cost in their filings.

Operating Leverage Formula 2: % Change in Operating Income / % Change in Sales

Operating Leverage Formula 3: Net Income / Fixed Costs

Operating Leverage Formula 4: Contribution Margin / Operating Margin

In practice, we tend to use the second formula: the % change in operating income divided by the % change in sales, because it’s the easiest one to apply when you have limited information.

However, the other formulas can be useful if you have additional insight into the company’s fixed vs. variable costs.

How to Interpret Operating Leverage in Real Life

This metric is MOST meaningful when you calculate it for companies in the same industry with roughly the same operating margins.

So it doesn’t make sense to use it to compare a software company to a manufacturing company, or to compare a biotech startup to a mature media company.

As a company’s operating leverage increases, each *percentage* of sales growth will translate into a higher *percentage* of operating income growth.

Consider Company A, with revenue of $1 billion, operating income of $200 million, and operating leverage of 2.0x, and Company B, with revenue of $1 billion, operating income of $200 million, and operating leverage of 1.0x.

“Operating leverage” means that when Company A’s revenue increases by 10%, its operating income will increase by 20%, so it will have operating income of $240 million on revenue of $1.1 billion.

On the other hand, Company B’s operating income will increase by only 10%, so it will rise to $220 million on revenue of $1.1 billion.
In the “Upside” case when sales increase, this is positive because Company A will earn more operating income from those additional sales.

But if sales decrease, Company A is worse off because it can’t cut its expenses to match its falling sales to the same degree that Company B can.

So it’s similar to debt in leveraged buyouts: more debt increases the potential rewards, but also the risk.

On balance, most investors prefer companies with high operating leverage simply because it makes it easier to earn out-sized returns – but it also depends on the investment firm’s strategy, the industry, and the companies involved.

Operating leverage measures a company’s fixed costs as a percentage of its total costs. It is used to evaluate the breakeven point of a business, as well as the likely profit levels on individual sales. The following two scenarios describe an organization having high operating leverage and low operating leverage.

High Operating Leverage

In a high operating leverage situation, a large proportion of the company’s costs are fixed costs. In this case, the firm earns a large profit on each incremental sale, but must attain sufficient sales volume to cover its substantial fixed costs. If it can do so, then the entity will earn a major profit on all sales after it has paid for its fixed costs. However, earnings will be more sensitive to changes in sales volume.

Low Operating Leverage

In a low operating leverage situation, a large proportion of the company’s sales are variable costs, so it only incurs these costs when there is a sale. In this case, the firm earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order to cover its lower fixed costs. It is easier for this type of company to earn a profit at low sales levels, but it does not earn outsized profits if it can generate additional sales.

Example of Operating Leverage

A software company has substantial fixed costs in the form of developer salaries, but has almost no variable costs associated with each incremental software sale; this firm has high operating leverage. Conversely, a consulting firm bills its clients by the hour, and incurs variable costs in the form of consultant wages. This firm has low operating leverage.

To calculate operating leverage, divide an entity’s contribution margin by its net operating income. The contribution margin is sales minus variable expenses.

For example, the Alaskan Barrel Company (ABC) has the following financial results:

Revenues$100,000Variable expenses    30,000Fixed expenses    60,000Net operating income  $10,000

ABC has a contribution margin of 70% and net operating income of $10,000, which gives it a degree of operating leverage of 7. ABC’s sales then increase by 20%, resulting in the following financial results:

Revenues$120,000Variable expenses    36,000Fixed expenses    60,000Net operating income  $24,000

The contribution margin of 70% has stayed the same, and fixed costs have not changed. Because of ABC’s high degree of operating leverage, the 20% increase in sales translates into a greater than doubling of its net operating income.

How to Use Operating Leverage

When using the operating leverage measurement, constant monitoring of operating leverage is more important for a firm having high operating leverage, since a small percentage change in sales can result in a dramatic increase (or decrease) in profits. A firm must be especially careful to forecast its sales in these situations, since a small forecasting error translates into much larger errors in both net income and cash flows.

Knowledge of the level of operating leverage can have a profound impact on pricing policy, since a company with a large amount of operating leverage must be careful not to set its prices so low that it can never generate enough contribution margin to fully offset its fixed costs.

What is the company's magnitude of operating leverage?

How is operating leverage impacted by higher variable costs?

Which of the following average costs per unit may be expected to decrease by the greatest percentage with an increase in the volume of units produced?

What is a contribution format income statement?