How to Calculate Operating Leverage: 8 Steps with Pictures

Instead, the decisive factor of whether a company should pursue a high or low degree of operating leverage (DOL) structure comes down to the risk tolerance of the investor or operator. But this comes out to only a $9mm increase in variable costs whereas revenue grew by $93mm ($200mm to $293mm) in the same time frame. Next, if the case toggle is set to “Upside”, we can see that revenue is growing 10% each year and from Year 1 to Year 5, and the company’s operating margin expands from 40.0% to 55.8%. Just like the 1st example we had for a company with high DOL, we can see the benefits of DOL from the margin expansion of 15.8% throughout the forecast period. On that note, the formula is thereby measuring the sensitivity of a company’s operating income based on the change in revenue (“top-line”).

Although a high DOL can be beneficial to the firm, often, firms with high DOL can be vulnerable to business cyclicality and changing macroeconomic conditions. If sales and customer demand turned out lower than anticipated, a high DOL company could end up in financial ruin over the long run. As a result, companies with high DOL and in a cyclical industry are required to hold more cash on hand in anticipation of a potential shortfall in liquidity. However, if revenue declines, the leverage can end up being detrimental to the margins of the company because the company is restricted in its ability to implement potential cost-cutting measures. When a company’s revenue increases, having a high degree of leverage tends to be beneficial to its profit margins and FCFs.

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1. A company with higher fixed costs has a higher degree of operating leverage (DOL), which then determines how much revenue is needed after costs are met — i.e. after the break-even point — to make a profit.
2. Outsourcing can be used to change the balance of this ratio by offering a move from fixed to variable cost and also by making variable costs more predictable.
3. An effective pricing structure can lead to higher economic gains because the firm can essentially control demand by offering a better product at a lower price.
4. Increasing utilization infers increased production and sales; thus, variable costs should rise.
5. This scenario is beneficial when sales are increasing, as profits grow rapidly.
6. In contrast, companies with low operating leverage rely more on variable costs, which means that any change in revenue will have a similar impact on operating profit, so their operating margin is less sensitive to changes in sales.

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1. Most investors, such as private equity firms and venture capitalists, prefer companies with high operating leverage because it makes growth faster and easier.
2. In addition, in this scenario, the selling price per unit is set to $50.00, and the cost per unit is $20.00, which comes out to a contribution margin of $300mm in the base case (and 60% margin).
3. In that case the break-even point for that company is lower, and a lower proportion of additional revenue will go toward profit, because variable costs go up as sales rise.
4. You can calculate the percentage increase or decrease by dividing the second year’s number by the first year’s number and subtracting 1.
5. A piece of equipment can be a great thing or it can hinder a company’s bottom line.
6. However, most companies do not explicitly spell out their fixed vs. variable costs, so in practice, this formula may not be realistic.

This indicates that a 1% increase in sales would increase operating income by 3.22%. Fixed costs do not vary with the volume of sales, whereas variable costs vary directly with sales volume. Degree of operating leverage is a measure, at a given level of sales, of how a change in sales will affect the net profit. Operating leverage can also be measured in terms of change in operating income for a given change in sales (revenue). Companies with low operating leverage experience more stable operating income as sales fluctuate.

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These types of expenses are called fixed costs, and this is where Operating Leverage comes from. As it pertains to small businesses, it refers to the degree of increase in costs relative to the degree of increase in sales. Since every business deals with a combination of fixed and variable expenses, understanding the degree of operating leverage is the next step in gauging a company’s path to profitability. The more fixed costs there are, the more sales a company must generate in order to reach its break-even point, which is when a company’s revenue is equivalent to the sum of its total costs. When sales increase, fixed assets such as property, plant, and equipment (PP&E) can be more productive without additional expenses, further boosting profit margins.

Operating Leverage Formula 4: Contribution Margin or Gross Margin / Operating Margin

The percentage change in profits as a result of changes in the sales volume is higher than the percentage change in sales. This means that a change of 2% is sales can generate a change greater of 2% in operating profits. Companies with high operating leverage experience significant changes in operating income with changes in sales. This scenario is beneficial when sales are increasing, as profits grow rapidly. However, it also means higher risk during periods of declining sales, as fixed costs remain constant regardless of sales volume. In the base case, the ratio between the fixed costs and the variable costs is 4.0x ($100mm ÷ $25mm), while the DOL is 1.8x – which we calculated by dividing the contribution margin by the operating margin.

The Operating Leverage measures the proportion of a company’s cost structure that consists of fixed costs rather than variable costs. A company’s operating leverage is the relationship between a company’s fixed costs and variable costs. A company with higher variable costs (and lower operating leverage) will see a smaller profit on each sale — but because it has lower fixed costs, it likely won’t need to increase sales as much to cover those items. In another example, a company may pay its corporate finance manager a salary, which represents a fixed cost. Yet that same company may also pay its line workers on a production basis, based on a per-product wage formula. In that scenario, the same company may have dual fixed and variable costs in the same cost pipeline (i.e., salaries and wages), making those costs semi-variable and semi-fixed costs.

High Operating Leverage Industries

High operating leverage can lead to significant profit increases with sales growth but also comes with higher risk during downturns. Conversely, low operating leverage provides stability but limits margin expansion potential. By analyzing operating leverage, businesses, investors, and analysts can make more informed decisions to optimize financial performance and manage risks effectively. Operating leverage helps assess the risk and potential profitability of a business.

Steve’s Bike Co. has the $20 in variable costs, but invested $250,000 in a machine that will replace the formula for operating leverage employees for 5 years, no matter how many bikes they make. The more fixed costs a company has relative to variable costs, the higher its operating leverage. A company’s operating leverage is the relationship between a company’s fixed costs and variable costs.

Because Walmart sells a huge volume of items and pays upfront for each unit it sells, its cost of goods sold increases as sales increase. When a company’s variable costs are higher, it has lower operating leverage (i.e. lower fixed costs). In that case the break-even point for that company is lower, and a lower proportion of additional revenue will go toward profit, because variable costs go up as sales rise. For example, a company with higher fixed costs has higher operating leverage than a company with higher variable costs. So the higher DOL company will see a substantive change in profits as sales increase past the break-even point. If the composition of a company’s cost structure is mostly fixed costs (FC) relative to variable costs (VC), the business model of the company is implied to possess a higher degree of operating leverage (DOL).