Operating leverage is the degree to which cost within a company is fixed. Fixed costs are costs that do not vary with sales. For example, the salary of a manager on a contract is fixed; that is regardless of the production level of a company the manager's pay would not change. Another example is rent, regardless of how much items are sold the rent for a store does not change. With this said, a company with a high operating leverage (in other words high fixed cost) have a high risk because it magnifies the effects of profit depending on sales. This could be measured by computing the degree of operating leverage (DOL) which is the percentage change in profit given a 1 percent change in sales.

An example from my Finance textbook (Fundamentals of Corporate Finance) shows a nice table that compares a high fixed cost company (high operating leverage) with a high variable cost company (low operating leverage) given different states of sales. So the following table is a replication of that table and not my own.

High Fixed Cost (High Operating Leverage)

High Variable Cost(Low Operating Leverage)

Sales:

Slump

Normal

Boom

Slump

Normal

Boom

Sales

13000

16000

19000

13000

16000

19000

- VC

10563

13000

15438

10920

13440

15960

- FC

2000

1560

- Dep.

450

= Profit

-13

550

1112

550

1030

VC = variable cost; FC = fixed cost; Dep = deprecation; Profit = before tax

As you can see that with a high operating leverage, the changes from a $3000 change in sales is more than the change from a company with a low operating leverage. This could be captured through DOL as well.

DOL = (% change in profits) / (% change in sales)

Where % change = (New value - old value) / (old value)

If we look at the normal to boom situations:

For the high fixed cost the percentage change in profits is 102.20% and the percentage change in sales is 18.75% DOL is as followed:

DOL = 102.20/ 18.75 = 5.45

For the high variable company the percentage change in profits is 87.30% and the percentage change in sales is 18.75% DOL is as followed:

DOL = 87.30/ 18.75 = 4.65

Thus the higher the DOL the more fixed cost a company has and the more risk it assumes if the sales slump. But it also means that when sales boom, the higher operating leveraged company will profit merrily!

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