Operating leverage measures the company's fixed expenses as a percentage of its overall costs. It is used to calculate a company's break-even point and profit margin. It is expressed as the Degree of Operating Leverage (DOL), and it is a ratio that calculates the sensitivity to sales of a company's operating income. The DOL, a financial metric, shows how changes in sales will impact the company's operating income.
Let's get through the details, including the operating leverage formula. Did you know? How can you possibly improve operating leverage? Before setting benchmarks for increasing your operating costs, improving operating leverage is possible. You need to cut off the costs so that it doesn't damage your ability to grow.
Did you know?
Henry Ford was among the first to employ operating leverage at a large scale.
Also Read: Accounting Ratios – Meaning, Types, Formulas
An Overview of Operating Leverage Formula
The level of operating leverage for a business is vital from an investor's perspective. At the same time, it indicates the risk of an investment. However, it also illustrates the level of the company. Like financial leverage is a result of the capital structure of a business, operating leverage comes out of the cost structure. If a firm has too many costs, which they can't change, they can run their business with high leverage.
Many mechanised companies can operate with higher leverage as they have replaced labour, a variable cost. It is because of the depreciation of machinery that they fix. There is debate about whether having large operating leverage can be good. Henry Ford was among the first to employ operating leverage at a huge scale and produce cars for less than their cost. Other people later adopted the concept, and high operating leverage was the standard.
Most companies want to reach an extremely high DOL to increase their profitability, and it will help them achieve their break-even point when they have enough sales to cover their expenses. In certain economic circumstances, fixed costs would theoretically increase operating revenue resulting in a reduction in the company's revenues.
What Is the Operating Leverage Meaning, and Why Is It So Important?
The calculation of operating leverage is important, and it will help determine the right price point for covering your expenses and earning profits. Additionally, it will help you understand how your business can use fixed-cost assets, including equipment or warehouses, for profit. In essence, if you can make more profit from fixed assets, you'll be able to improve the operating leverage.
Operating Leverage Example
One way for a business seeking to improve its operational leverage is through automating its assembly line. Nearly all auto manufacturers have either fully or partially automated assembly lines, and automation reduces the direct and variable labour costs, increasing fixed costs.
This makes business operations even riskier as the automaker now must produce more of its products. Automakers must make ends meet due to the increased fixed cost and greater operating leverage. Operational leverage is a gauge of operational risk since it reveals the number of fixed costs you must eliminate to achieve break-even.
What Is the Operating Leverage Formula?
The DOL is a financial ratio that measures how an organisation's operating income fluctuates based on the percentage of change in its sales. Operating income is a business's profits after paying for its operating expenses. You can determine your operating income for a particular year by using this formula for operating income.
Operating Income = Net Income minus Operating Costs
While some people might be using the terms interchangeably, operating income differs from earnings before interest and taxes (EBIT) even though they're both similar. The EBIT formula includes non-operating both income and expenses, and it provides the profit or losses that aren't related to the company's core business.
The formula for operating income does not include this, and it is based on direct expenses. For example, the ones directly connected to the creation of the company's product and some indirect costs, like those related to the maintenance of office space. As long as you're aware of the number of sales your business makes and the method of calculating operating income, figuring out how to calculate your DOL isn't a big deal.
What are Lows and Highs?
A company can be either high or low in DOL. A high DOL generally means that the business has a higher fixed cost proportion. This implies that increasing sales may result in a rise in operating income. However, it also indicates that the business has a higher operational risk.
If the economy is in a slump or the company struggles to market its products or services, its profits could drop due to its high fixed expenses. They are the same regardless of the amount the business is selling.
A low DOL usually indicates a business with a higher cost of variable ratio, also referred to as an expense variable ratio. This means that it has more variable costs and low fixed expenses if companies with a lower DOL have more sales and variable costs. This means that operating profits won't increase at the same rate for companies with a higher DOL and fewer variable costs.
However, companies that have low DOLs can lower their fixed expenses. They don't need to sell as many products to cover these costs. It can deal better with economic fluctuations and downturns.
In determining whether your business has high or low DOL, examine your company's performance compared to other companies in your industry. You should not be looking at companies worldwide, and certain industries are more likely to have higher fixed costs than other industries.
Also Read: Know How To Calculate Cost of Capital With Examples
Low Operating Leverage vs High Ratio: What Should My Business Include?
In general, the higher leverage of operating is more beneficial than low leverage since it allows businesses to make huge profits from every sale. However, businesses with a low level of operating leverage could have a greater chance of making profits when they have a lower sales volume. Additionally, companies with a high degree of operating leverage can make them more susceptible to income fluctuations.
If the economy is doing well, companies could see a greater profit. But, a downturn in the economy could result in a drop in earnings because of their significant fixed expenses. However, starting with making a great business plan can give you more opportunities to succeed.
High Operating Leverage
When there is excessive operating leverage, a big part of the company's expenses is usually fixed expenses.
- In this case, the firm makes a profit from every incremental sale. However, it must achieve sufficient sales to pay for the significant fixed expenses.
- If the business does this, it will mean that the company's entity responsible for its business activities will be able to earn many sales after paying for all of its fixed expenses.
- In such instances, the earnings are more susceptible to fluctuations in the number of sales.
Low Operating Leverage
If you face low leverage in operating, many of a business's sales are its variable expenses. This means that the cost is only incurred when there's the possibility of a sale.
- In this scenario, the increase in the cost of every income results in a lower income. However, it doesn't generate the same sales to pay for the lower fixed expenses.
- It is easy for these businesses to profit with low sales, but they cannot make huge profits if they can make more sales.
How Do I Use Operating Leverage?
Using the measurement of operating leverage, continuous surveillance of operating leverages is vital for companies with high operating leverage. This is because any small variation in sales could result in massive increases or decreases in profit. A company should be particularly careful when forecasting the sales in these situations since a tiny percentage mistake can cause a bigger error in the cash flow and net income.
The concept of the amount of operating leverage could significantly impact pricing. We said that a business with high operating leverage should be cautious not to set the price so low. It may not generate sufficient contribution margins in its business to meet its fixed expenses completely.
Conclusion
You already know the operating leverage definition, formula and uses. You should be able to calculate your DOL if you are responsible for small-business bookkeeping. Take a look at your general ledger to identify the key figures.
You can also find them in your accounting program. Follow the vital steps to calculate your DOL, and keep checking it periodically to make sure it isn't changing.
Follow Khatabook for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.
