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How does Operating Leverage impact a business?
Operating leverage is a component of fixed costs. Companies that have higher operating leverage or the firms with a lower fraction of variable cost and higher portion of fixed costs have higher operating leverage. This means that most of the costs cannot be scaled down in the phases of declining sales. Such an arrangement increases the risk and makes it increasingly hard to forecast the sales.
However, operating leverage is not bad in all situations. While it can magnify losses in periods of lower sales, it can do the same to profits when good business conditions prevail.
Operating Leverage and Sales
When sales increase, a business with high operating leverage benefits because the fixed costs of the business remain the same. Therefore, each incremental sale brings more profit to the company. Leveraging fixed costs is the term that is used to express the situation of more production from the same fixed costs. So, companies having higher fixed costs benefit from sales during such periods.
However, when sales go down, these companies must bear the loss for each incremental product sale. Therefore, it can also lead to more losses when the business condition is not appropriate.
Business Risk
The magnitude of variance is a measure of a business’s operating risk. Business risk is constituted of various factors such as macroeconomic situations, customer demand changes, changes in government regulation, positioning of the competitors, etc. Some of these factors are external, while others are internal that can be managed by the companies.
Operating leverage risks are manageable by the company depending on the factors affecting them.
Operating leverage is the biggest contributor to the internal risks the businesses face when the situation is against the flow of profitability.
Therefore, the net effect of operating leverage is proportional to the business outcome. Companies having higher operating leverage have a linear relationship with net profits. When operating risk is higher, the business may earn more profits from each incremental sale; while when the sale is low, it may face incremental losses.
Example
The Airline Industry is a good example that bears the brunt of operating leverage. The fixed costs of the industry players are quite high, and the industry depends on demand to a larger extent. So, the companies operating in the Airline Industry face tough situations when other players (competitors) tend to capture their market share. Depending on the market conditions, the companies may also face the risk of bankruptcy when the operating leverage is lower than the required rates.
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