Operating leverage refers to the amount of fixed costs a company has. Here the term fixed costs can be referred to as fixed operating expenses such as, rent for the office premises, lease payments etc. Important to note, that, the greater operating leverage has higher variability on the operating earnings of the company as most of the costs involved are fixed
In the accounting and finance literature, the degree of operating leverage is calculated as the percentage change in operating income (EBIT) that results from a given change in percentage of sales.
However, even this performance measurement tool has associated advantages and disadvantages and the same are discussed below:
Benefit of Operating Leverage
Improved operating profits: The primary benefit of the operating leverage is that with the fixed costs of the company stagnant, the operating profits of the company can increase with increase in sales figures. In other words, a company with higher operating leverage has the potential to generate higher profits for the company as compared to the company with lower operating leverage. For Instance, the variable cost for a media company which sells music CD’s is very low and includes packaging and cost of CD’s is very low as compared to the fixed costs relating to research and development. Thus, once the company reaches the breakeven point, the contribution that sales make to profits is much higher than it would be if a greater portion of the costs were variable.
Problems associated with Operating Leverage
Inability to reach break-even unit: The primary disadvantage of operating leverage will arise for a company that have high fixed costs and furthermore, it faces difficulty in selling enough units so as to reach the break-even point on a particular investment. In other words, just as the use of operating leverage can multiply the profits of the company, the inability of the company to reach break-even point can magnify losses too.
Thus, comparing the pros and cons of operating leverage, it seems that the company must maintain a balance between risk and rewards associated with it.
Kaplan Schweser. (2011). Measures of Leverage . In K. Schweser, Schweser CFA Level 1 Notes (pp. 60-63). Boston.
Yahoo Finance. (n.d.). Panera Bread Company: Income Statement. Retrieved June 11, 2014, from Yahoo Finance: http://finance.yahoo.com/q/is?s=PNRA+Income+Statement&annual