Operating leverage is the degree to which a company incurs a combination of fixed and variable costs in its operations.

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Why is operating leverage important?

Understanding operating leverage helps businesses assess their risk, break-even point, and potential for profitability in response to changes in sales volume.

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An easy way to understand operating leverage is:

Think of it as a see-saw. Just like a small change in weight can have a big effect on a see-saw's balance, operating leverage shows how sensitive a company's profits are to changes in sales.

How to Calculate Operating Leverage

Operating leverage is a measure of how sensitive a company's operating income is to changes in its sales revenue. It represents the degree to which a company can increase its operating income by increasing its revenue.

To calculate operating leverage, use the following formula:

Operating Leverage = % Change in Operating Income / % Change in Sales Revenue

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To calculate the percentage change in operating income and sales revenue, use the following formulas:

% Change in Operating Income = (New Operating Income - Old Operating Income) / Old Operating Income

% Change in Sales Revenue = (New Sales Revenue - Old Sales Revenue) / Old Sales Revenue

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For example, let's consider a company with the following financial information:

Old Sales Revenue: $1,000,000

New Sales Revenue: $1,100,000

Old Operating Income: $200,000

New Operating Income: $240,000

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First, calculate the percentage change in sales revenue and operating income:

% Change in Sales Revenue = ($1,100,000 - $1,000,000) / $1,000,000 = 0.10 or 10%

% Change in Operating Income = ($240,000 - $200,000) / $200,000 = 0.20 or 20%

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Then, calculate the operating leverage:

Operating Leverage = 20% / 10% = 2

In this example, the company's operating leverage is 2, which means that for every 1% increase in sales revenue, the operating income will increase by 2%.

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We use operating leverage to understand how our fixed costs relate to variable costs as we scale operations. High operating leverage means that our business can increase revenue without a corresponding increase in operating costs, significantly boosting profitability as sales grow.