Question

Describe what operating leverage is, and the difference between the degree of pre-tax cash flow operating leverage and the degree of accounting operating leverage (use formulas in your explanations). Under what conditions would a corporate decision-maker be more interested in the accounting metric?

Answer 1

Operating leverage

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.

1. High operating leverage. 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.

2. Low operating leverage. 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.

For example, 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.

What Does Operating Leverage Tell You?

The operating leverage formula is used to calculate a company’s break-even point and help set appropriate selling prices to cover all costs and generate a profit. The formula can reveal how well a company is using its fixed-cost items, such as its warehouse and machinery and equipment, to generate profits. The more profit a company can squeeze out of the same amount of fixed assets, the higher its operating leverage.

One conclusion companies can learn from examining operating leverage is that firms that minimize fixed costs can increase their profits without making any changes to the selling price, contribution margin or the number of units they sell.

Formula

The operating leverage formula is calculated by multiplying the quantity by the difference between the price and the variable cost per unit divided by the product of quantity multiplied by the difference between the price and the variable cost per unit minus fixed operating costs.

DOL = [Quantity x (Price – Variable Cost per Unit)] / Quantity x (Price – Variable Cost per Unit) – Fixed Operating Costs

By breaking down the equation, you can see that DOL is expressed by the relationship between quantity, price and variable cost per unit to fixed costs. If operating income is sensitive to changes in the pricing structure and sales, the firm is expected to generate a high DOL and vice versa.

Financial Metrics

The word metrics refers to measurement. Businesspeople speak of software performance metrics, customer satisfaction metrics, and financial metrics, for instance. "Metrics" in each case reveal—measure—specific characteristics of data sets: SW performance data, customer satisfaction data, or financial data.

Most people in business—even outside of finance or accounting—have heard the term financial metrics. And, most are aware of examples such as return on investment or earnings per share. Not everyone understands the unique strengths and weaknesses of these metrics, however. And, not everyone appreciates their special data requirements. As a result, many businesspeople use financial metrics blindly, or in ways that signal misleading information.

Each Financial Metric Sends a Unique Message

Each financial metric conveys a unique message about a body of economic data. In that way, financial metrics are like descriptive statistics. The statistical average (arithmetic mean), for instance, reveals the "typical" value in a data set.

Similarly, each financial metric reveals specific characteristics of the economic dataset. Usually, those characteristics are not readily apparent when merely reviewing the data. Cash flow investment metrics, for instance, measure investment performance by evaluating the series of cash inflows and outflows that follow from the investment. One of these metrics, the payback period, measures the time required for returns to cover costs. Potential investors can compare payback periods of different investments, to help decide which is the better investment.

Prudent investors, however, will also analyze the same investment choices with other metrics besides payback period. Investors might, for instance, also use net present value (NPV), return on investment (ROI), and internal rate of return (IRR) to analyze the same investment choices.

• Each of these compares investment gains to investment costs in a different way and, as a result, each measures investment performance differently.
• Each metric also has its "blind spots"—insensitivities—to particular characteristics of the dataset.

Consequently, decision-makers are always well advised not to base critical decisions on just one metric.

Two Families of Business Metrics

Most financial metrics in business belong to one of two families:

Firstly, Cash Flow Metrics

Cash flow metrics help evaluate streams of cash flow events, such as investment outcomes or "business case" cash flow estimates. Familiar cash flow metrics include payback period, breakeven point, net present value (NPV), return on Investment (ROI), internal rate of return (IRR), and cumulative average growth rate (CAGR).

Secondly, Financial Statement Metrics

Financial statement metrics, not surprisingly, are derived from financial statement figures. Business people use these metrics to evaluate a firm's financial position and financial performance. Well-known financial statement metrics include current ratio, inventory turns, the debt to equity ratio, and earnings per share.

Two Metrics Family Portraits

The article provides a high-level overview of both financial metrics families.

• Sections below introduce the essential members of each family, briefly, along with the metric's definition and purpose.
• The text also provides links to other Encyclopedia pages that explain, calculate, and interpret these metrics in depth.