Question

Jacob Andrews, president of Video Adventure, has heard about operating leverage and asks you to explain this term. What is operating leverage? How does a company increase its operating leverage?

Answer 1

Operating leverage is a measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. A business that makes sales providing a very high gross margin and fewer fixed costs and variable costs has much leverage. The higher the degree of operating leverage, the greater the potential danger from forecasting risk, where a relatively small error in forecasting sales can be magnified into large errors in cash flow projections.

Operating Leverage = Contribution Margin / Net Operating Income

Operating leverage may be used for calculating a company’s breakeven point and substantially affecting profits by changing its pricing structure. Because businesses with higher operating leverage do not proportionately increase expenses as they increase sales, those companies may bring in more revenue than other companies. However, businesses with high operating leverage are also more affected by poor corporate decisions and other factors that may result in revenue decreases.

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.