MBA students, as future investors and managers of businesses, need to understand the different characteristics of businesses deeply. Our graduate-level tutors guide students through a range of finance, economics, accounting, operational, and statistical frameworks, tools, and techniques for analyzing and understanding the various characteristics of businesses. One method to understand the operating characteristics of companies is to examine the degree of operating leverage. We cover the following topics related to operating leverage on this page.
- What is Operating Leverage?
- How do you compute Operating Leverage? Operating Leverage Formula?
- Why Operating Leverage Matters?
- Operating Leverage: An Example
- Is Operating Leverage Good or Bad?
- Alternative ways to look at Operating Leverage? Alternate Operating Leverage Formula?
- How does Fixed Cost come into the Operating Leverage Picture?
- What Happens To Operating Leverage If There Are No Fixed Costs!?
- Difference Between Operating And Financial Leverage
- Tutoring for Operations Leverage and Financial Leverage
What is Operating Leverage?
Operating leverage measures how sensitive a company’s profits are to its sales. In other words, operating leverage shows you how much a company’s profits change when sales change.
How do you compute Operating Leverage? Operating Leverage Formula?
There are a few ways to measure operating leverage. However, the most direct method to calculate operating leverage is:
Operating Leverage = % Change In EBIT / % Change In Sales
If you examine the formula, you will notice that the percentage change in EBIT is in the numerator and the percentage change in sales is in the denominator. This effectively gives you the ratio of change in EBIT to the change in sales! In other words, it tells you if the company’s sales increase or decrease by $1, the company’s EBIT increases or decreases by the operating leverage ratio!
Why Operating Leverage Matters?
Operating leverage is essential for investors to understand because it indicates how much profit will change in response to changes in sales.
A company’s profits may be low now. But if the company has high operating leverage and you are investing after significant capital expenditures are complete, you can hope to ride a wave of increasing profits. On the other hand, if a company’s profits are low and it has high operating leverage, even a slight dip in sales will cause its profits to decline.
Operating Leverage: An Example
Let us look at a simple example of operating leverage. The financials of a company are provided at two stages. In stage 2, the company’s sales have increased by 10%. We also assume that the variable costs increase by the proportion of 10%.
This results in a 15% increase in EBIT. Using the operating leverage formula, we will see that operating leverage is 1.5! This means that for every dollar increase in profits, the company’s operating earnings will increase by $1.5!
Is Operating Leverage Good or Bad?
Operating leverage is neither good nor bad! It is just a characteristic of a business. Some investors seek to set up their business with a high degree of operating leverage, especially when they expect increases in revenues in the future. In contrast, other investors seek to set up their business with a low degree of operating leverage, as they prefer to reduce the risk of losses in the event of a sales decline.
Alternative ways to look at Operating Leverage? Alternate Operating Leverage Formula?
While the previous section gives you the standard approach to measuring operating leverage, there are other ways to think about operating leverage.
If you think about operating leverage deeply, operating leverage is driven by the fixed costs in the business. Look at the difference in the numerator and denominator of the operating leverage formula we used above. The key difference in the numerator and denominator of the operating leverage formula is driven by the amount of fixed costs used in the business. It is the amount of fixed costs that drives operating leverage. So you can look at operating leverage as
Operating leverage = Contribution Margin / Operating Profits
Contribution Margin here is revenues minus variable costs. Contribution Margin is the money left over to cover fixed costs and earn profits.
How does Fixed Cost come into the Operating Leverage Picture?
Operating leverage is driven by fixed costs. Fixed costs leverage operating income. Fixed costs do not change with a change in sales. So when there is an increase in sales, fixed costs stay the same, but there will be an increase in operating income. This will result in a higher percentage increase in operating income when compared to the percentage increase in sales. This results in operating leverage.
What Happens If There Are No Fixed Costs!?
While there are only rare situations in which a firm does not have fixed costs, let us consider what happens if a firm does not have fixed costs. If a firm has no fixed costs, the percentage change in sales will be equal to the percentage change in operating profit. This implies that if a firm has no fixed costs, then the operating leverage formula gives us an operating leverage of one!
An operating leverage of one indicates that there will be no operating leverage as indicated in the above illustration. It is only when there are fixed costs that we will see the percentage change in operating profits be more than the percentage change in sales, resulting in operating leverage.
Difference Between Operating And Financial Leverage
Many of our students mix up operating and financial leverage. While operating and financial leverage may have some common objectives, they are not the same or similar in construction.
Financial Leverage
Financial leverage is related to the capital structure of the firm. Financial leverage measures the ability of a firm to use its capital structure. It measures the financial risk of a firm. Financial leverage shows the relationship between operating income and net income. Just like operating leverage discussed on this page above, financial leverage is neither good nor bad. The optimal financial leverage for a firm depends on many factors covered here.
Operating Leverage
Operating leverage is related to a firm’s sales, operating costs, and fixed costs. Operating leverage measures the relationship of a firm’s sales to its operating income. Operating leverage is a measure of the operating risk of a firm. It shows the relationship between sales and EBIT. Just like financial leverage discussed on this page above, operating leverage is neither good nor bad. The optimal operating leverage for a firm depends on many factors, including the outlook of the firm and the industry.
Tutoring for Operating Leverage, Financial Leverage or other related Operations or Finance Topics
GraduateTutor’s finance tutors offer live online private tutoring for operating leverage, financial leverage or other related operations or finance topics. We cover a number of other courses such as Investments (MFIN8801), Corporate Finance (MFIN8807), Management of Financial Institutions (MFIN8820), Financial Econometrics (MFIN8852). Please email or call us if we can provide corporate finance tutoring or, for that matter, graduate-level tutoring or any other quantitative course you will encounter in a b-school program.