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Operating Leverage: Definition, Calculation & Examples

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  • 0:04 Operating Leverage Defined
  • 0:25 High and Low Operating…
  • 1:42 Operating Leverage Calculation
  • 2:46 Operating Leverage…
  • 3:48 Lesson Summary
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Lesson Transcript
Instructor: Elizabeth Aube-VanPatten
Explore the definition and importance of operating leverage, and take a look at examples to assist you in the accounting process. When you are finished with the lesson, there is a quiz to test your knowledge.

Operating Leverage Defined

Operating leverage can be defined as a percentage of fixed costs within a company's operating structure. It is used to evaluate a potential break-even point for operating costs or determining what you need to sell in order to cover what you've already spent. In addition, it can also be used to determine profit levels from individual sales.

High and Low Operating Leverage

As you learn about operating leverage, it is also important to understand the difference between a high operating leverage and a low operating leverage.

High operating leverage describes a situation in which a company has a large amount of monthly fixed costs. Let's look at an example: Each month, Company A has a number of fixed costs, including rent, factory space, and production materials. Company A must earn a large profit on each sale in order to cover the funds already spent. The higher the number of fixed costs, the higher the operating leverage. Remember, high operating leverage means greater risk! Companies with a fixed cost each month must generate a high volume of sales to push beyond the break-even point.

Low operating leverage occurs when a company has a low amount of monthly fixed costs. Here's an example of how this works: Each month, Company B only incurs costs if there is a sale of their product. For example, Company B sells homemade dog treats out of their home. These dog treats are only produced when an order is placed. Since all dog treats are made to order, Company B doesn't need to have as a high of a sales volume as Company A in order to cover the company's expenses. Low operating leverage means low risk.

Operating Leverage Calculation

To calculate operating leverage, divide an entity's contribution margin by its net operating income. The contribution margin is sales minus variable expenses. In order to calculate operating leverage, do the following:

  1. Define the business' revenues, variable costs per unit sold, and fixed costs
  2. Divide the total revenues by the number of units sold to determine the revenue per unit sold or the sale price per unit
  3. Subtract the fixed costs and operating expenses from the total revenues
  4. Divide the difference between revenues and fixed costs and operating expenses by the number of units made to determine the variable cost per unit made
  5. Calculate the contribution margin, which is the variable profit per unit sold
  6. Multiply the contribution margin by the number of units sold to determine the total variable profit
  7. Divide the total variable profit by the operating expenses

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