Operating Leverage

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.

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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.

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.

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