What is operating leverage?

June 25, 2012

Learn about operating leverage and how one can compare operating leverage across companies.

1. Definition of operating leverage

In the long run, all costs are variable. But in the short run (e.g., business cycle), some costs are fixed: these costs can have a leverage effect on operating income. To learn more about costs, refer to the tutorial on Accounting Cost Behavior.

So what is operating leverage?

Operating leverage is how a company's net income reacts to the changes in sales volume. Operating leverage reflects the relationship between variable and fixed costs in a company’s cost structure.

Operating leverage essentially measures the proportion of fixed costs in a company’s cost structure and how a change in sales volume affects the company’s profit. In other words, operating leverage affects profit stability.

Company’s cost structure (i.e., a relative proportion of fixed and variable costs) depends on many factors, including long-run trend in sales, sales fluctuations, management’s attitude towards risk, etc. Companies in the same industry can have different cost structures and thus different operating leverages.

Companies with high operating leverage have the following cost structure:

  • High fixed costs*
  • Low variable costs

Companies with low operating leverage have an opposite cost structure:

  • Low fixed costs*
  • High variable costs

(*) Important to note, fixed costs are high or low in relation to variable costs.

So why does it matter if operating leverage is high or low?

When operating leverage is high, a change in sales results in a large change in profit (loss). On the other hand, when operating leverage is low, a change in sales results in a small change in profit (loss).

Key points about operating leverage are summarized in the table below:

 

High Operating
Leverage

Low Operating
Leverage

Fixed costs

High

Low

Variable costs

Low

High

Profit stability (when sales fluctuate)

Lower

Greater

Good years (↑ sales)

Greater profits

Lower profits

Bad years (↓ sales)

Greater losses

Lower losses

Contribution margin

Higher

Lower

Break-even point

Higher

Lower

Margin of safety

Lower

Higher

As we can see from the table above, operating leverage is important for cost-volume-profit considerations. To learn more about break-even point and margin of safety, refer to the tutorial on Accounting Cost-Volume-Profit Analysis.

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