Financial Education

Operating leverage can be measured if the breakdown of fixed cost and variable cost in a company’s operating structure is known. Operating leverage is normally based upon operating income to avoid muddying the signal with financial leverage or taxes.

Computing operating leverage would be easy if the proportion of fixed and variable costs could be known with certainty. Consider a stylized example:

Operating leverage is computed by dividing the contribution margin (revenues less variable costs) by the operating income. In this case, operating leverage is 1.50 (300/200). So, a 10% increase in revenues should yield a 15% increase in operating income (10% * 1.5). As seen above, a 20% increase in sales yielded a 30% increase in operating income. Since our example had no interest expense, there is no financial leverage and the increase in taxes and net income was also 30%.

The company benefits from operating leverage as it grows since fixed costs do not increase and existing fixed costs are “spread” across higher revenues. As a percentage of revenues, the fixed costs shrink. Of course operating leverage will also work against the firm if revenues fall since fixed costs do not fall accordingly. In fact, in our stylized example, if revenue were to fall by 20%, operating income would fall by 30%.

Operating leverage also does not remain constant; it must be recomputed each period as the relationships among contribution margin, fixed costs, and operating income change. Statistical techniques such as regression analysis can be useful for this purpose. A shortcut method of approximating operating leverage is to divide the change in operating income by the change in sales:

Percentage Change in Operating Income

Percentage Change in Revenues

For more information, see all articles on: Common Size Analysis, Financial Statement Analysis, Fundamental Analysis, Ratio Analysis

See also:

Price/Book, Operating Leverage and Market Returns

Operating Leverage: A Case Study

The Income Statement: Operating versus Non-Operating Components

Does Institutional Ownership Improve Corporate Operating Performance?

Interest and Dividends: Differences Between US GAAP and International Accounting Standards