How Leverage Works

Operating leverage is a measure of how much profit a company makes from its fixed costs. The more profit a company generates from its fixed costs, the higher its operating leverage. Operating leverage can be calculated using a variety of formulas, but the most common of which is the ratio of variation in contribution margin to the rate of change in operating profit.

Table of Contents

Calculate operating leverage

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Calculate the contribution margin. Contribution margin is total revenue minus variable costs. Variable costs are costs that increase with each volume of sales. Cost of goods, commission costs, and delivery costs are some of the basic variable costs. Subtract variable expenses from total revenue to calculate the contribution margin. ^{[1] X Research Source}

For example, suppose Company ABC has total sales of $100,000 in December 2015. Variable costs include: cost of goods – $30,000; Commission – 20,000 USD; Delivery cost – 10,000 USD.
Contribution balance is $100,000 won$ $U$ $S$ $EASY$ $-$ $30,000 won$ $U$ $S$ $EASY$ $-$ $20,000 won$ $U$ $S$ $EASY$ $-$ $10,000 won$ $U$ $S$ $EASY$ $=$ $40,000 won$ $U$ $S$ $EASY$ ${displaystyle 100,000USD-30,000USD-20,000USD-10,000USD=40,000USD}$ $100,000USD-30,000USD-20,000USD-10,000=40,000USD$ .

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Calculate profit from business. Operating profit is total revenue minus all operating expenses except interest and taxes. If you have deducted variable expenses, then subtract more from fixed costs to calculate profit from the business. Fixed costs include advertising, insurance, rent, service charges (electricity, water, etc.), and salaries. ^{[2] X Research Source}

Assume that Company ABC’s fixed costs have: advertising – $2,000; Insurance – $5,000; Rent – 3,000 USD; services – $ 2,000; Salary – $18,000.
Total fixed costs are $30,000.
Operating profit is the total revenue minus variable and fixed costs.
For Company ABC, the total revenue is $100,000. Variable costs are $60,000 and fixed costs are $30,000.
Thus, profit from business of ABC = $100,000 won$ $U$ $S$ $EASY$ $-$ $60,000 won$ $U$ $S$ $EASY$ $-$ $30,000 won$ $U$ $S$ $EASY$ $=$ $10,000 won$ $U$ $S$ $EASY$ ${displaystyle 100,000USD-60,000USD-30,000USD=10,000USD}$ $100,000USD-60,000USD-30,000USD=10,000USD$ .

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Calculate operating leverage. Divide the contribution margin by the profit from the business. Going back to the above example, company ABC has a contribution margin of $40,000 and operating profit of $10,000. ^{[3] X Research Sources} .

Operating leverage = contribution margin / operating profit.
$40,000 won$ $U$ $S$ $EASY$ $/$ $10,000 won$ $U$ $S$ $EASY$ $=$ $4$ ${displaystyle $40,000/10,000USD=4}$ $40,000USD/10,000USD=4$
Company ABC’s operating leverage is 4.

Analysis of operating leverage

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Evaluate profitability using a measure of operating leverage. Operating leverage tells you how quickly net profit from the business grows with sales. In the above example, ABC Company’s operating leverage is 4. This means that its net profit from the business grew 4 times as much as its sales. However, this number varies depending on the ratio of fixed and variable costs ^{[4] X Research Source}

The higher the fixed cost as a percentage of total costs, the greater the operating leverage will be.
Higher operating leverage means your net income grows at a faster rate.

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Analyze the effect of higher fixed costs and lower variable costs. Company XYZ has the same revenue and contribution margin as Company ABC (revenue = $100,000, operating profit = $10,000). However, company XYZ’s variable costs are $30,000 and its fixed costs are $60,000. ^{[5] X Research Sources}

Contribution balance is $100,000 won$ $U$ $S$ $EASY$ $-$ $30,000 won$ $U$ $S$ $EASY$ $=$ $70,000 won$ $U$ $S$ $EASY$ ${displaystyle 100,000USD-30,000USD=70,000USD}$ $100,000USD-30,000USD=70,000USD$ .
Net profit from trading is $100,000 won$ $U$ $S$ $EASY$ $-$ $30,000 won$ $U$ $S$ $EASY$ $-$ $60,000 won$ $U$ $S$ $EASY$ $=$ $10,000 won$ $U$ $S$ $EASY$ ${displaystyle 100,000USD-30,000USD-60,000USD=10,000USD}$ $100,000USD-30,000USD-60,000USD=10,000USD$ .
Operating leverage = contribution margin / operating profit.
$70,000 won$ $U$ $S$ $EASY$ $/$ $10,000 won$ $U$ $S$ $EASY$ $=$ $7$ ${displaystyle 70,000USD/10,000USD=7}$ $70,000USD/10,000USD=7$ .
Thus, the net profit from business of company XYZ increased 7 times compared to sales.

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Determine the impact of growth in sales on profit margins. Use operating leverage to calculate how much profit margin will increase as sales increase. Multiply operating leverage by the percentage increase in sales. This is the percentage by which you can estimate your profit margin to increase. ^{[6] X Research Source}

Assume that the two companies in the above examples both experience a 10% increase in sales.
Company ABC, with operating leverage of 4, will increase its net profit margin by 40% with a 10% increase in sales. $($ $ten$ $%$ $*$ $4$ $=$ $40$ $%$ $)$ ${displaystyle (10%*4=40%)}$ $(10%*4=40%)$ .
Company XYZ with operating leverage of 7, will increase its net profit margin by 70% with sales increasing by 10% $($ $ten$ $%$ $*$ $7$ $=$ $70$ $%$ $)$ ${displaystyle (10%*7=70%)}$ $(10%*7=70%)$ .
As a result, you can use operating leverage to quickly calculate the impact of changes in sales on your net operating profit, without the need to prepare detailed financial statements.

Risk assessment by operating leverage

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Determine break-even point. The break-even point is the level of revenue achieved just enough to cover operating costs, including all fixed and variable costs. When breakeven, your profit margin is 0 USD. Therefore, the operating leverage is infinite. Operating leverage increases as you get closer to breakeven. ^{[7] X Research Sources}

For example, suppose company ABC in the example above has revenues of $75,000, variable costs of $45,000, and fixed costs of $30,000.
Contribution balance will be $75,000 won$ $U$ $S$ $EASY$ $-$ $45,000 won$ $U$ $S$ $EASY$ $=$ $30,000 won$ $U$ $S$ $EASY$ ${displaystyleUSD 75,000-45,000USD=30,000USD}$ $75,000USD-45,000USD=30,000USD$ .
Net profit from trading will be $75,000 won$ $U$ $S$ $EASY$ $-$ $45000$ $U$ $S$ $EASY$ $-$ $30,000 won$ $U$ $S$ $EASY$ $=$ $0$ $U$ $S$ $EASY$ ${displaystyle 75,000USD-45000USD-30,000USD=0USD}$ $75,000USD-45000USD-30,000USD=0USD$ .
Operating leverage will be $30,000 won$ $U$ $S$ $EASY$ $/$ $0$ $U$ $S$ $EASY$ $=$ $infinite$ ${displaystyle $30,000/0USD={text{ infinite }}}$ $30,000USD/0USD={text{ infinite }}$ .

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Assess the company’s risk profile. High operating leverage means that the company can significantly increase profits as sales increase. However, high operating leverage also means that the company invests a lot of money in fixed costs, such as machinery, real estate, and wages. If the economy slows down and sales drop, the company won’t have much of a chance to cut costs to maintain its profitability. ^{[8] X Research Sources}

This is why investors should be cautious when investing in companies with high operating leverage.

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Apply the active leverage indicator carefully. This is because operating leverage can sometimes misrepresent a company’s ability to increase profit margins. For example, a company with operating leverage of 7 should be able to increase its profit margin seven times as much as its sales. But in reality, to increase revenue, the company may need more workers or expand space. The cost of this activity will increase fixed costs, and so the company’s profit margin will not increase as expected from operating leverage. ^{[9] X Research Source}

Steps

Calculate operating leverage

Analysis of operating leverage

Risk assessment by operating leverage

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