Operating leverage
Operating leverage is a financial efficiency ratio used to measure what percentage of total costs are made up of fixed costs and variable costs in an effort to calculate how well a company uses its fixed costs to generate profits.
If fixed costs are higher in proportion to variable costs, a company will generate a high operating leverage ratio and the firm will generate a larger profit from each incremental sale. A larger proportion of variable costs, on the other hand, will generate a low operating leverage ratio and the firm will generate a smaller profit from each incremental sale. In other words, high fixed costs mean a higher leverage ratio that turns into higher profits as sales increase. This is the financial use of the ratio, but it can be extended to managerial decision-making.
Managers use operating leverage to calculate a firm’s breakeven point and estimate the effectiveness of the pricing structure. 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. If the firm generates adequate sales volumes, fixed costs are covered, thereby leading to a profit. However, to cover for variable costs, a firm needs to increase its sales.
If a firm generates a high gross margin, it also generates a high DOL ratio and can make more money from incremental revenues. This happens because firms with a high degree of operating leverage (DOL) do not increase costs proportionally to their sales. On the other hand, a high DOL incurs a higher forecasting risk because even a small forecasting error in sales may lead to large miscalculations of the cash flow projections. Therefore, poor managerial decisions can affect a firm’s operating level by leading to lower sales revenues.
The formula of Operating leverage
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.
Managers need to monitor DOL to adjust the firm’s pricing structure toward higher sales volumes as a small decrease in sales can lead to a dramatic decrease in profits.