The term operating leverage is commonly met in the financial world. Applying it helps both companies and investors achieve higher returns on their assets. Its main function is helping an organization see whether they earn substantial profits or not. If the answer is positive, that specific firm will cover all its costs, especially the fixed ones. In other words, it is all about the break-even point, when the earnings are equal to total costs, which means the profits are zero.
What Is Operating Leverage?
This tool measures and evaluates the manner in which a company mixes its fixed and variable costs combination. As I previously mentioned, this shows whether a firm is profitable or not. A higher operating leverage is reached when an organization experiences a decreased fixed cost amount, calculated monthly.
There are three different measures when it comes to operating leverage:
- Fixed to total costs – if the rate of fixed costs increases it might show a decreased quality of earnings. This leads to an accentuated earnings instability.
- The ratio of operating income to the total sales value – if this ratio increases the company’s earnings decrease regarding As you know from the previously described point, an increase in fixed costs leads to higher earnings instability.
- Net income vs. fixed costs – when this ratio decreases the above-described results are bound to happen.
How to Obtain More Operating Leverage?
Any company can obtain a higher leverage at the moment in which it provides high gross margins. This means that the fixed costs are fewer. On the other hand, having a significantly increased operating leverage might not be as good for your forecasting risk. For example, if a small error happens in sales forecast it can have a great negative impact on the cash flow projections.
It is difficult to obtain the same value of these indices, especially when applied to different companies and industries. Its result becomes relevant only when it is compared to several organizations from the same industry or activity field.
How to Calculate the Operating Leverage?
Its formula is the following one:
Qu x (P – Var. CpU) / Qu x (P – Var. CpU) – Fixed Op. Cost
- Qu – quantity.
- P – price.
- Var. CpU – variable cost per unit.
- Fixed Op. Cost – fixed operating cost.
What is DOL?
This stands for Degree of Operating Leverage, and it is a ratio that shows the effect that a certain amount of leverage has on a firm’s earnings, also called EBIT. EBIT means “earnings before interest and taxes. The formula for this financial tool is the following:
DOL= % Change in EBIT / % Change in Sales
To properly calculate your company’s operating leverage, you will have to define some things first such as the business’ revenue, fixed and variable costs, contribution margin, and more. It might seem like a complicated thing, but once you get the hang of it, this tool will come in handy for your organization’s success and profitability.
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