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Operating leverage

 
Investment Dictionary: Operating Leverage
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A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs.

1. A business that makes few sales, with each sale providing a very high gross margin, is said to be highly leveraged. A business that makes many sales, with each sale contributing a very slight margin, is said to be less leveraged. As the volume of sales in a business increases, each new sale contributes less to fixed costs and more to profitability.

2. A business that has a higher proportion of fixed costs and a lower proportion of variable costs is said to have used more operating leverage. Those businesses with lower fixed costs and higher variable costs are said to employ less operating leverage.

Investopedia Says:
The higher the degree of operating leverage, the greater the potential danger from forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be magnified into large errors in cash flow projections. The opposite is true for businesses that are less leveraged. A business that sells millions of products a year, with each contributing slightly to paying for fixed costs, is not as dependent on each individual sale.

For example, convenience stores are significantly less leveraged than high-end car dealerships.

Related Links:
Find out how fixed and variable costs interact to shed new light on old companies. Operating Leverage Captures Relationships
Both measure performance, but sometimes they tell a very different picture. We explain why. Understanding The Subtleties Of ROA Vs ROE
Learn this easy-to-understand technique of analyzing a company's financial statements and reports. Introduction To Fundamental Analysis
Learn the factors to consider when comparing the different programs offered by various lenders. Home-Equity Loans: The Costs


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Real Estate Dictionary: Operating Leverage
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Automatic increases in the Net Operating Income or Cash Flow of income-producing real estate when income and expenses increase at the same rate; further enhanced when expenses are fixed.
Example: In the example shown in Table 37, Gross Income and Operating Expense both increase by 5% in a year, while Debt Service is fixed. The cash flow increases by 30% because of operating leverage.

Accounting Dictionary: Operating Leverage
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Measure of fixed costs in a company's operating structure. High operating leverage magnifies changes in earnings so that small changes in sales lead to earnings instability. Operating leverage can be measured through the following ratios: (1) fixed costs to total costs; (2) percentage change in operating income to the percentage change in sales volume; and (3) net income to fixed charges. An increase in (1) and (2) or a decrease in (3) shows higher fixed charges, resulting in greater instability.

Wikipedia: Operating leverage
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The operating leverage is a measure of how revenue growth translates into growth in operating income. It is a measure of leverage, and of how risky (volatile) a company's operating income is.

Contents

Definition

There are various measures of operating leverage,[1] which can be interpreted analogously to financial leverage.

Costs

One analogy is "fixed costs + variable costs = total costs ..similar to.. debt + equity = assets". This analogy is partly motivated because (for a given amount of debt), debt servicing is a fixed cost. This leads to two measures of operating leverage:

One measure is fixed costs to total costs:

\frac{\text{FC}}{\text{TC}}=\frac{\text{FC}}{\text{FC}+\text{VC}}

Compare to debt to value, which is

\frac{\text{Debt}}{\text{Assets}}=\frac{\text{Debt}}{\text{Debt}+\text{Equity}}

Another measure is fixed costs to variable costs:

\frac{\text{FC}}{\text{VC}}

Compare to debt to equity ratio:

\frac{\text{Debt}}{\text{Equity}}

Both of these measures depend on sales: if the unit variable cost is constant, then as sales increase, operating leverage (as measured by fixed costs to total costs or variable costs) decreases.

Contribution

Contribution margin is a measure of operating leverage: the higher the contribution margin is (the lower variable costs are as a percentage of total costs), the faster profits increase with sales. Note that unlike other measures of operating leverage, in the linear Cost-Volume-Profit Analysis Model, contribution margin is a fixed quantity, and does not change with Sales.

DOL and Operating income

Operating leverage can also be measured in terms of change in operating income for a given change in sales (revenue).

The Degree of Operating Leverage (DOL) can be computed in a number of equivalent ways; one way it is defined as the ratio of the percentage change in Operating Income for a given percentage change in Sales (Brigham 1995, p. 426):

\text{DOL} = \frac{\%\text{ change in Operating Income}}{\% \text{ change in Sales}}

This can also be computed as Total Contribution Margin over Operating Income:

\text{DOL} = \frac{\text{Total Contribution}}{\text{Operating Income}} = \frac{\text{Total Contribution}}{\text{Total Contribution} - \text{Fixed Costs}} = \frac{(\text{P}-\text{V})\times \text{X}}{(\text{P}-\text{V})\times \text{X} - \text{FC}}

Alternatively, as Contribution Margin Ratio over Operating Margin:

\text{DOL} = \frac{\text{Contribution Margin Ratio}}{\text{Operating Margin}}

For instance, if a company has sales of 1,000,000 units, at price $50, unit variable cost of $10, and fixed costs of $10,000,000, then its unit contribution is $40, its Total Contribution is $40m, and its Operating Income is $30m, so its DOL is

\frac{\$\text{40m}}{\$\text{30m}} = 1 \frac{1}{3} \approx 1.33

This could also be computed as 80%=$40m/$50m Contribution Margin Ratio divided by 60%=$30m/$50m Operating Margin.

It currently has Sales of $50m and Operating Income of $30m, so additional Unit Sales (say of 100,000 units) yield $5m more Sales and $4m more Operating Income: a 10% increase in Sales and a 10% \times 1 \frac{1}{3}= 13 1/3% increase in Operating Income.

Assuming the model, for a given level of sales and profit, the DOL is higher the higher fixed costs are (an example): for a given level of sales and profit, a company with higher fixed costs has a higher contribution margin, and hence its Operating Income increases more rapidly with Sales than a company with lower fixed costs (and correspondingly lower contribution margin).

If a company has no fixed costs (and hence breaks even at zero), then its DOL equals 1: a 10% increase in Sales yields a 10% increase in Operating Income, and its operating margin equals its contribution margin:

\frac{\text{Operating Income}}{\text{Sales}}=\frac{\text{Unit Price} - \text{Unit Variable Cost}}{\text{Unit Price}}

DOL is highest near the break-even point; in fact, at the break-even point, DOL is undefined, because it is infinite: an increase of 10% in sales, say, increases Operating Income for 0 to some positive number (say, $10), which is an infinite (or undefined) percentage change; in terms of margins, its Operating Margin is zero, so its DOL is undefined. Similarly, for a very small positive Operating Income (say, $.1), a 10% increase in sales may increase Operating Income to $10, a 100x (or 9,900%) increase, for a DOL of 990; in terms of margins, its Operating Margin is very small, so its DOL is very large.

DOL is closely related to the rate of increase in the operating margin: as sales increase past the break-even point, operating margin rapidly increases from 0% (reflected in a high DOL), and as sales increase, asymptotically approaches the contribution margin: thus the rate of change in operating margin decreases, as does the DOL, which asymptotically approaches 1.

Industry-specific

Examples of companies with high operating leverage include companies with high R&D costs, such as pharmaceuticals: it can cost billions to develop a drug, but then pennies to produce it. Hence from a life cycle cost analysis perspective, the ratio of preproduction costs (e.g. design widgets) versus incremental production costs (e.g. produce a widget) is a useful measure of operating leverage.

Outsourcing

Outsourcing a product or service is a method used to change the ratio of fixed costs to variable costs in a business. Outsourcing can be used to change the balance of this ratio by offering a move from fixed to variable cost and also by making variable costs more predictable.

See also

References

  1. ^ Operating and Financial leverage

Brigham, Eugene F. (1995), Fundamentals of Financial Management 

External links


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Investment Dictionary. Copyright ©2000, Investopedia.com - Owned and Operated by Investopedia Inc. All rights reserved.  Read more
Real Estate Dictionary. Dictionary of Real Estate Terms. Copyright © 2004 by Barron's Educational Series, Inc. All rights reserved.  Read more
Accounting Dictionary. Dictionary of Accounting Terms. Copyright © 2005 by Barron's Educational Series, Inc. All rights reserved.  Read more
Wikipedia. This article is licensed under the Creative Commons Attribution/Share-Alike License. It uses material from the Wikipedia article "Operating leverage".  Read more