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What is Operating Leverage?
Operating leverage is a tool that measures a company’s fixed costs as a percentage of its overall costs. It is often used to evaluate the breakeven point of a business and the profit from overall sales. When expressed as the degree of operating leverage (DOL), it represents a financial ratio that calculates the sensitivity of a company’s operating income to its sales. As such, the DOL is a financial metric that shows how a change in the company’s sales will affect the company’s operating income.
High Operating Leverage
In the case of high operating leverage, a large portion of a company’s costs are generally fixed costs.
In this situation, the firm earns a good profit on each incremental sale, but it also must attain sufficient sales volumes to cover the substantial fixed costs.
When the company does so, then the entity of the business operations will earn a major profit on overall sales after it has paid the entire amount for its fixed costs.
However, in such situations, earnings will be more vulnerable to changes in the volume of sale.
Low Operating Leverage
In the case of low operating leverage, a large portion of a company’s sales is its variable costs. Therefore, the cost only incurs when there is a sale.
In such a case, the incremental cost from each income results in a smaller profit, but it does not generate as much sales volume to cover the lower fixed costs.
It is easier for such companies to earn a profit at low sales levels, but it is incapable to earn big profits if it can generate extra sales.
How to Use Operating Leverage?
When using the operating leverage measurement, constant monitoring of the operating leverage is very important for a firm having high operating leverage because a small change in sales can cause a huge increase or decrease in profits. A firm has to be especially careful to forecast the sales in such situations because a small percentage error in forecasting could lead to a much larger error in both net income and cash flows.
The idea of the level of the operating leverage can lead to a profound impact on pricing policy because a company with large operating leverage must be careful not to set the prices so low that it can never generate enough contribution margin to fully cover its fixed costs.
High and Low Operating Leverage – Which is Better?
As higher levels of operating leverage allow companies to earn better profits on each incremental sale, it is considered better. However, a company with lower operating leverage can find it easier to earn a profit from its sales.
Moreover, higher operating leverage is subject to macroeconomic situations too. So, it is the environment of the business that is important in making it sure whether higher or lower operating leverage is better for a business.
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