Operating leverage measures a company’s fixed costs as a percentage of its total costs (fixed and variable). It is used to evaluate the break-even point of a business as well as the likely profit levels on individual sales.
If a large proportion of a company’s costs are fixed, it is considered to have high operating leverage. It earns a large profit on each sale, but it must attain sufficient sales volume to cover its substantial fixed costs.
If a large proportion of the company’s costs are variable, not fixed, the company earns a smaller profit on each incremental sale, but does not have to generate much sales volume in order cover its lower fixed costs. It’s easier for this type of company to earn a profit at low sales levels.
To calculate your Operating Leverage: Sales minus Variable Expenses = Your Contribution Margin. Then take your contribution margin and divide it by net operating income.
Variable expenses $20,000
Fixed expenses. $70,000
Net operating income. $10,000
From this example, your contribution margin is $80,000 and your operating leverage is 8, which is considered high.
It’s critical to monitor operating leverage when you work in a high leverage model. Any decrease in sales can affect profitability. It can also have an impact when you’re considering growth strategies or a decline in business because you must consider covering your fixed costs in any pricing changes you make.