Explained: What is operating leverage and its impact on the margins of companies

Operating leverage is a useful metric to find out how well a company can squeeze out more profit from the same amount of fixed cost.

Operating leverage is a useful metric to find out how well a company can squeeze out more profit from the same amount of fixed cost. 

It is a formula to measure the degree to which a company/ business can increase operating profit by increasing revenue. A business that has high fixed costs compared to variable costs has high operating leverage. Fixed expenses are those which normally do not change from month to month like Office Rent, Insurance Costs, Electricity& Internet Bills and a large number of administrative expenses. These expenses are bound to be incurred irrespective of the change in revenue generation.

 In effect, by scaling up the revenue engine, companies with high operating leverage can generate higher operating margins as a large number of expenses are fixed and do not increase in the same proportion. The companies with high operating leverage will however perform poorly when the revenue engine is decelerated or halted. Airlines, hotels and heavy capital-intensive companies like cement, and real estate witnessed burnout during the pandemic. 

Low-operating-leverage companies may have high variable costs that vary directly with their sales but have lower fixed costs to cover each month like retail stores. In this case, if a company has low operating leverage, the larger sales will not significantly improve profitability as the variable costs increase proportionately with sales volume. 

How to calculate Operating Leverage 

Degree Of Operating Leverage = Contribution Margin 

                                                           Operating Profits 

Where Contribution Margin = (Sale Value per Unit – Variable Cost per Unit) X Units Sold and, 

Operating Profit = Contribution Margin – Fixed Operating Costs. 

As discussed earlier, some industries because of their business model have higher fixed costs and hence it is desirable to compare companies within the same industries to better understand which companies have operating leverage over their peers.