Every business has its operating structure and future goals for its growth in the market. The management's decision on fixed costs is a huge part of the business plan. Fixed costs are constant expenses that are incurred regularly. They do not change with fluctuations in sales and production quantities because they are not directly associated with operating activities. Fixed costs are also referred to as indirect costs. These costs include rental and mortgage fees, management salaries, insurance, and utility costs.
Operating leverage is an analysis of these fixed costs in conjunction with variable costs. High operating leverage means a high proportion of fixed costs compared to variable costs. Low operating leverage is having a low proportion of fixed operating costs compared to variable costs.
The operating leverage business definition is the percentage of fixed costs relative to the company's operating structure. Knowing the operating leverage definition is extremely important as it will greatly impact the pricing structure of goods and services. If the company has high operating leverage, it needs a good profit cushion to cover the cost of the fixed expenses. A high-profit requirement may give the company no choice but to price the goods higher. If the company, on the other hand, has low operating leverage having minimal fixed costs, it will be able to lower its price and compete in the market.
The benefits of having high operating leverage include making more money from additional sales because no additional production costs are needed. Thus, high operating leverage will benefit the company when business is on the rise and products are in demand and soaring. It is a high risk if the business starts, but fixed expenses will save a lot for the increasing production volume once it takes off.
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The degree of operating leverage (DOL) measures how well a company generates profit using its fixed cost. This operating leverage factor helps calculate the effect of any change in sales on the business' earnings. The higher the DOL, the more sensitive the company's income is to any sales changes.
Operating leverage presents fixed costs as a proportion of its total cost. It may also be used as a break-even point indicator to figure out the right value of sales that is just enough to cover the business's expenses such that there is no profit. Companies with a large proportion of fixed costs require bigger sales or revenue to cover such expenses. Companies with low operating leverage have a large proportion of variable costs that may prevent huge profits per sale but put the business at a lower risk of being unable to pay the fixed costs.
There are three different ways of calculating operating leverage. The formulas may be categorized based on the required data:
Operating leverage may be determined in terms of sales, fixed, and variable costs. The data may be taken from the information on an income statement. If the quantity of production is available, sales is calculated by getting the product of price per unit and the number of goods produced. Likewise, the variable cost is calculated by multiplying the variable costs per unit and the variable costs.
| DOL = (Sales - Variable Costs)/(Sales - Variable Costs - Fixed Costs) |
An alternative formula to determine the degree of operating leverage is the proportion of contribution margin on operating income. The contribution margin is the amount left of the revenue when variable costs are deducted. Operating income is further deducting fixed expenses from the contribution margin.
| DOL = Contribution Margin / Operating Income |
The third formula for determining operating leverage uses percentage changes in operating income and sales. The data used for this formula require a pair of variables to compare ( yearly, quarterly, or monthly)
| DOL = Change in Operating Income / Change in Sales |
A more detailed step-by-step instruction for determining the operating leverage and costs is shown in this section for each formula.
| DOL = (Sales - Variable Costs)/(Sales - Variable Costs - Fixed Costs) |
| DOL = Contribution Margin / Operating Income |
The contribution margin is defined as the variable cost profit or the result when the variable cost is deducted from revenue.
Operating income is defined as the clean profit or the profit after both variable, and fixed costs are removed.
| DOL = Change in Operating Income / Change in Sales |
| Year 1 | Year 2 | |
| Sales/Revenue | $400,000 | $500,000 |
| Operating Expenses | $150,000 | $175,000 |
Thus, the three formulas for determining the operating leverage depend on readily available data. Whichever is closest to the available data is the most appropriate. A real-life example is described as follows:
AC Solutions is a tech company with a huge fixed cost for its start-up and promotional expenses. To pay its software developers and to build rental and periodic utility costs, AC Solutions pay $650,000 for fixed costs. Business sales are expected to reach 400,000, selling at $19 for each tech gadget. The production manager estimated the variable cost to be $1.75/ unit.
To get the degree of the operating leverage ratio, the given information may be used:
The degree of operating leverage is 6,900,000/6,250,000 = 1.10
One commonly used measure for operational proficiency is the degree of the operating leverage ratio or the DOL. Depending on the available data, there are three related formulas in calculating DOL. Knowing operating leverage is extremely important because it will hugely influence the product's pricing structure. In its determination, the first step is to gather data on the business's revenue and variable costs per unit sold and its fixed cost. From this information, the contribution margin may be calculated by deducting the total variable cost from the revenue amount; Removing the fixed expenses from the contribution margin figures the operating income. Operating income is the amount left of the company's revenue after deducting variable and fixed expenses. Finally, dividing the contribution margin by the operating income gives the operating leverage ratio. This is the same if the total variable profit is divided by the operating expenses, which is usually the last and final step in calculating the operating leverage.
A company with high operating leverage has a large number of fixed costs. This generates high risk and is commonly due to massive capital outlay and start-up costs. It is important to ensure that fixed costs are low at the beginning of a business operation. If a company's fixed costs and contribution margins stay the same, a small increase in sales can lead to a high increase in profit for a business with high operating leverage.
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The following business case is designed to help students apply their knowledge of the calculation and interpretation of Operating Leverage.
Your name is Elmer WannaRetire. You're 58 years old and have decided to increase your retirement savings by investing in stocks. You are a big fan of skiing and thus, you find two public companies that produce and sell skis: Silly Skis and Sassy Skis. You only have enough money to invest in one of these companies. Your priority is to invest in a low-risk business since you remember your father once told you, "Invest in businesses that don't have a high portion of fixed costs. That way, if there is a downturn in sales, they won't get stuck with huge losses." You are a risk-averse person by nature and thus, you want to follow your father's advice.
You do research and obtain the following data for each of these companies. The data is presented in thousands.
| Company | Silly Skis | Sassy Skis |
|---|---|---|
| Revenue $ | 300 | 1,000 |
| Variable Costs $ | 150 | 300 |
| Fixed Costs $ | 100 | 600 |
| Net Operating Income $ | 50 | 100 |
1. The contribution margin in dollars is calculated as sales revenue minus variable expenses. The contribution margin in percentage is calculated by dividing the contribution margin in dollars by the sales.
| Company | Silly Skis | Sassy Skis |
|---|---|---|
| Revenue $ | 300 | 1,000 |
| Variable Costs $ | 150 | 300 |
| Contribution Margin $ | 150 | 700 |
| Contribution margin % | 50% | 70% |
2. Degree of Operating leverage = Contribution margin $ / Operating income
| Company | Silly Skis | Sassy Skis |
|---|---|---|
| Contribution Margin $ | 150 | 700 |
| Net Operating Income $ | 50 | 100 |
| Degree of Operating leverage | 3 | 7 |
3. The answer is Silly Skis because its degree of operating leverage is lower.
High operating leverage means that the company is running on high fixed costs. This is good for a business that is on the rise where demand is increasing. Producing more does not anymore add to production cost because the fixed cost is constant regardless of the quantity of production.
Operating leverage is a measure that determines how fixed costs are proportioned in the total costs of the business. It helps analysts determine the effect of changes in sales on the company's earnings.
Operating leverage is calculated by getting the percentage change in earnings before interest and taxes (EBIT) over the percentage change in sales. There are alternative ways of solving it. It may also be determined using the ratio of change in operating income over the change in sales or the contribution margin ratio over operating income.
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