- What is operating leverage?
- Formula for operating leverage
- Example of operating leverage
- Why operating leverage matters to every business?
- TallyPrime: Accounting made easy
What is operating leverage?
Operating leverage lets you understand how well your business is currently using fixed and variable costs to generate profits and increase revenue. Using the operating leverage formula and calculating the operating leverage reveals how much of the total costs you are spending on fixed costs and variable costs. It can also help you find your break-even point and ensure your pricing structure is as good as it can be. Every business should ensure it calculates operating leverage at some point to ensure the management can take correct decisions.
Business owners often wonder if they should aim for a low operating leverage ratio or if they should aim for a high operating leverage ratio. The answer is, it depends. For most businesses, it is best to aim for high operating leverage because every sale means you will earn big profits. However, some businesses find it more practical and simpler to increase their profits with low sales when they have low operating leverage. The only issue with high operating leverage is that it depends on the economic conditions. If the conditions are favorable, then high profits can be earned. But if they are not, then the earnings can take a dip.
Generally, businesses that spend majorly on marketing and research and development are the ones that have high operating leverage such as software companies. They have a cost structure whereby they have certain fixed costs. The costs don’t change that much whether the software company sells one copy of its software or a thousand. Once it makes sufficient sales to fully cover all its fixed costs, the sales thereafter go to the profits of the software company. Although the software company has marketing and research costs, the fixed costs ensure they can generate higher profits once those costs are covered.
Retail businesses often have low operating leverage because they have lower fixed costs usually and they have to deal with large variable costs. Additionally, they are able to sell a higher volume of goods and so the cost of goods sold is often high as they make sales due to the upfront payment. Retailers have inventories that they need to store and these costs can be substantial depending on the retailer. If it is a large store then the inventory costs are going to be large but if it is small then the costs aren’t going to be too high.
Formula for operating leverage
The operating leverage formula is simple when you have the various factors that it includes in the formula. The formula is as follows.
Operating leverage = (Sales – Variable costs) / Profits
Or
Operating leverage = (Quantity x (Price – Variable cost per unit)) / ((Quantity x (Price – Variable Cost Per Unit)) – Fixed Operating Costs)
The quantity refers to the quantity of goods sold and the price refers to the price at which each item was sold. The fixed operating costs refer to the costs that are incurred regardless of whether the sales are high or low. The variable cost per unit refers to the costs associated with the production or manufacturing of each product.
Example of operating leverage
Here is an example to show you how the operating leverage formula can be used.
Let us say a business has fixed costs as it continuously develops and markets its products. The total of these fixed costs has been found to be $500,000 as it is used to pay salaries and wages. The cost per unit is $0.05. The business sells 25,000 units at a rate of $10 each.
Now that we have fixed costs, variable cost per unit, quantity, and price, we can calculate the operating leverage with the formula.
Operating leverage = (25,000 x (10 – 0.05)) / (25,000 x (10 – 0.05) – 500,000)
Operating leverage = (248,7500) / (251,250)
Operating leverage = 0.99 or 99%
What does this mean? It means that when there is a 10% increase in business sales, it will equate to a 9.9% increase in profits and thereby revenue. You can also check the operating leverage by changing the price to see how much profit you can make because the fixed costs will remain the same. This allows you to see how much profit you will earn when the price per unit is changed and when the number of units sold is different.
Why does operating leverage matter to every business?
The operating leverage lets you know that you are pricing your products correctly so that every cost is covered and you are still generating profits. Oftentimes, the products are priced so low that even though the sales are being made better than ever before, they are insufficient to pay the high fixed costs and variable costs. Businesses must understand and think of ways to efficiently use their fixed costs because these costs will remain the same regardless of the number of sales the business makes. When businesses are able to find ways to increase profits with the existing fixed assets, they can increase their operating leverage.
When a business has high operating leverage, it means that it needs to make a high number of sales to ensure it covers all its fixed costs. It also indicates that the business is using its fixed assets in order for the core business functions to run smoothly and it is highly dependent on them. This shows it can increase its profit margin quickly. When a business has low operating leverage, it means that it uses variable assets to ensure the smooth running of its core business functions. In this case, the gross margin is low. The degree of operating leverage ratio allows you to determine the sales impact on profit and earning.
Operating leverage is particularly useful to creditors, managers, and analysts because it shows them the risk involved with a particular business. While a high degree of operating leverage can be a good sign, it also means it carries a high risk when the economic conditions change for the worse. Similarly, a business with a low degree of operating leverage shows that it carries a comparatively smaller risk when the economic conditions change and can still generate profits. Of course, when assessing a business the operating leverage isn’t the only factor that is considered, but it provides a way to analyze the business nonetheless.
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