Operating leverage is a measure of the amount of fixed costs relative to a company’s total cost structure.
Fixed costs are those costs which do not fluctuate proportionally with sales. In contrast, variable costs are those costs which do fluctuate with sales. The company’s total cost structure is the sum of fixed and variable costs.
Operating leverage magnifies a company’s income relative to changes in sales.
For example, consider two companies. Company A has $1 million in sales, $200,000 in variable costs, and $500,000 in fixed costs. If the company’s sales increase 20% to $1.2 million, its variable costs, which are proportional to sales, increase to $240,000. Fixed costs remain at $500,000. The 20% increase in sales generates a profit of $460,000. The 20% increase in sales led to a 53% increase in profit. If the company’s sales decrease 20% to $800,000, variable costs are $160,000 and fixed costs remain at $500,000. Thus, profit is $140,000, which is a decline of 53%. The $500,000 in fixed costs have magnified the change in profit relative to the change in sales.
Company B has $1 million in sales, $400,000 in variable costs and $300,000 in fixed costs. If sales increase 20%, the company’s profit is $420,000. A 20% increase in sales leads to a 40% increase in profit. Similarly, a decline of 20% in sales leads to a 40% decrease in profit.
Company A above employs a higher level of fixed costs relative to total costs and thus has a higher amount of operating leverage, as evidenced by the larger increase and decrease in profits relative to the same change in sales. Company B employs a lower level of fixed costs relative to total costs and thus a lower amount of operating leverage.
