Operating Leverage

Operating Leverage = % Change in Profits that Results from a % Change in Sales.

Operating Leverage = % Change in Profits/% Change in Sales.

Example:
If a business increases profits by 30% from a 10% rise in sales, its Operating Leverage = 3 times.

Operating leverage is a fundamental tool in establishing a company's profit sensitivity to changes in demand.

If a business (A) has a high operating leverage, with a high level of fixed costs and low unit variable costs (high profit contribution), the profits accelerate quickly to the right of the break even point when demand increases, but losses are sustained equally quickly as demand falls away.

If a business (B) has a low operating leverage, with low fixed costs and high variable costs, profits increase relatively slowly as demand increases and losses are equally limited when demand falls away.

Company A will come under intense pressure to achieve volume sales to avoid falling into heavy losses.

Company B is often found within smaller companies with smaller flexible systems and low fixed assets, but these companies tend to have less risk and less reward attached.

Reference Pages

Marginal Costing