What Is Operating Leverage (And How to Calculate and Use It)
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Accountants and financial professionals evaluate fixed and variable costs to determine a company's risk and profitability. Calculating the operational leverage can help you measure and assess how well a company is leveraging its fixed-cost assets to generate a profit. Understanding the various ways of calculating an organization's operating influence and cost structures can help you make important financial decisions. In this article, we define what operating leverage is, describe how it's used, explain how to calculate it, and provide examples to help with further understanding.
What is operating leverage?
Operating leverage is a cost-accounting formula that measures a company's fixed costs compared to its total costs. Companies use this formula to calculate their break-even point to help determine prices and maximize profit. This value can be helpful in assessing and managing risk, which can inform various financial decisions. Financial analysts may also use these values to determine potential profitability.
An accountant or financial manager may evaluate the fixed costs that remain steady each period, against the variable costs, which change as production rates change. For example, where rent and property taxes represent fixed costs, the sales commission is variable. As a company sells more products, the sales increase with the company's cost. Total cost is the combination of all fixed and variable costs. Here are the different types of leverage you may observe:
High operational leverage: A higher value indicates a company has a large proportion of fixed costs compared to its total costs. For example, an airline company has large fixed expenses, such as airplane maintenance and employee salaries, which stay relatively the same even as the seat sales vary.
Low operational leverage: A lower value occurs when a company's fixed costs are relatively low. For example, a restaurant has more variable than fixed costs such as ingredients, where the business uses more ingredients when production is high and fewer during slow periods.
Using operating leverage
Anyone interested in a company's risk levels and future profitability can use operating influence. For example, an investor who wants to buy stocks in a company or a financial professional assessing a company's growth might assess the company's leverage. Employees interested in how a business is doing might also evaluate this value to assess the company's risk level.
When calculating or assessing a company's leverage, it's important to consider the industry in which the business is operating. Some industries have a naturally higher operational influence than others. When evaluating a company's influence, it's helpful to compare values within one industry to assess risk and potential profits. It's also beneficial to track leverage over time to identify any trends that may occur in the natural cycle of business. Here are the company indicators that this financial component can inform:
Investors can use this financial metric to assess risk, usually associating a low leverage with lower risk. Profits can vary each period, but it's essential that a company pays its fixed costs regardless of revenue. If a company has low fixed costs, it may be able to cover them easier than a company with a higher leverage.
Potential future profitability
A higher leverage may indicate the opportunity for higher potential profits. When revenue increases, the fixed costs remain constant, so a company with a higher leverage can make a higher profit. A company with a low leverage has a lower potential for profitability because as revenues increase, the variable costs also increase.
Optimal use of fixed-cost items
Evaluating the leverage can tell you how well a company is using its fixed costs items, such as plant, property, and equipment (PPE) assets. PPE assets include a warehouse, machinery, and other existing equipment that's used to create revenue. The more profit a company can generate through its existing PPE assets, the higher its operational leverage.
How to calculate operating influence using cost structure
If you have access to a company's cost structure information, you can calculate the operative influence by following these steps:
Determine the number of units. Review the sales data to determine the number of units produced or sold.
Calculate the unit price without variable costs. Determine the price per unit and subtract the variable cost per unit.
Determine the fixed operating costs. Review the balance sheet to calculate the fixed operating costs to use in the cost structure formula.
Apply the values to the formula. Input the four values into the formula, multiplying the units by price without variable cost, divided by the same value minus the fixed costs.
Here's the formula for calculating leverage using cost structure:
Operating leverage = (Number of units sold x (Unit price - Variable cost per unit)) / (Number of units sold x (Unit price - Variable cost per unit) - Fixed costs)
How to calculate operational leverage using a cost ratio
If you have limited access to a company's financial information, you can still calculate the leverage using an estimated cost ratio formula. Here are the steps for calculating leverage using a cost ratio:
Calculate the change in income. Calculate the change in income by subtracting the previous year's income from the current year, dividing that by the previous year's income to find the percent change.
Calculate the change in sales. Subtract the previous period's sales from this period's sales, dividing that by the previous period's sales to determine the percent change.
Apply the values to the formula. Divide the percent change in income by the percent change in sales to determine the leverage value.
Here's the formula for calculating leverage using a cost ratio:
Operating leverage = % change in income / % change in sales
Examples of operational leverage
Here are examples to demonstrate how you can calculate the operational leverage of a company:
Example of a company with a high operating influence
This example shows how you use the cost structure formula on a company with high operational leverage:
Oak Tree Theatre wants to determine its operational leverage, so they engage with an accountant to calculate the value using the cost structure formula. The accountant reviews the balance sheet to add the property taxes, theatre equipment, and maintenance to determine total fixed costs of $200,000. The variable costs averaged $5 per ticket sold. In one year, the theatre sold 10,000 tickets at a price of $40 per ticket. The accountant inputs the values into the equation to determine the leverage:
10,000 (40 - 5) / (10,000 (40 - 5)) - 200,000 = 2.3
The accountant determines the degree of leverage is 2.3. This means that for every 1% increase in the company's sales, the accountant expects the operating income to grow by 2.3%. Oak Tree Theatre uses this number to compare to other local theatre companies to see how relatively safe or profitable the theatre may be.
Example of a company with a low operating influence
This example shows how you can use the cost structure formula on a company with low leverage:
Wavewood Restaurant is up for sale and the potential buyer wants to evaluate the company's leverage value. They engage with an accountant to review the financial documents. Since the current owner owns the building and has relatively low fixed costs, the accountant adds the property taxes and utilities to determine the fixed costs are $10,000 per year. The average variable cost is $10 per meal and the restaurant charges $20 per meal. This past year, they sold 100,000 meals. Using the cost structure formula, they calculate:
100,000 (20-10) / (100,000 (20-10)) - 10,000 = 1.1
The accountant determines the degree of leverage is 1.1. This means that for every 1% of change in the company's sales, the accountant can expect the operating income to change by 1.1%. Since the number is close to 1, this indicates a safer company with lower potential profits. The potential buyer compares this number to other local restaurants with available data to determine the risk and potential profitability, to assess the viability of the investment.
Example using cost ratio
This example demonstrates how you can calculate leverage with limited access to a company's cost structure:
An investor is considering buying stock in Tech Crunch. They want to calculate the leverage before they invest to assess the company's risk and potential profits. They evaluate the balance sheet to determine the net income of last year was $1.2 million and $1.44 million for this year. The investor calculates a 20% increase in income by subtracting the $1.2 million from the $1.44 million and dividing it by $1.2 million. They perform the same calculations with the sales data to determine a sales increase of 15% from the previous year. The investor uses the cost ratio formula:
20 / 15 = 1.3
The investor determines that Tech Crunch has a degree of operating influence of 1.3. This means that for every 1% change in sales, the investor can expect the income to increase by 1.3%. They use these values to determine if they want to invest in the company.
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