To calculate the degree of operating leverage, divide by net operating income.

A degree of operating leverage is a financial ratio companies use to measure the amount of operating leverage in their operations. Operating leverage is the comparison of fixed costs to variable costs, with firms having high fixed costs leading to an increase in the company’s operating leverage. The formula to calculate a company’s degree of operating leverage is the contribution margin divided by the company’s net income. Earnings before interest and taxes reduce the gross sales of a company by the company’s expenses, which will include fixed costs.

Most companies have a mix of fixed and variable costs in their operations. Fixed costs stay the same for a long period of time and are not directly influenced by the amount of production output. Common fixed costs include mortgage or loan payments, rent, and lease payments. Variable costs change as companies increase or decrease their production output, and include items like materials, production, labor, or the overhead a company uses to run its production equipment or facilities. High fixed costs are seen as negative because companies cannot get rid of the costs quickly — or at all — in order to offset the reduction of sales revenue.

To calculate the degree of operating leverage, assume the following: a company’s contribution margin and net income in January is $60,000 US Dollars (USD) and $20,000 USD, respectively. The degree of operating leverage formula presents a basic calculation that is relevant to determining the effects of fixed costs on a company. The contribution margin is sales revenue less the company’s variable costs needed to produce goods and services. The remaining figure represents the sales dollars that a company can use to pay for fixed costs. If this figure is too low, the company will not generate sufficient capital to pay for normal business operations and will need to secure external financing to make up these capital shortfalls.

Operating leverage relates to a company’s fixed vs. variable costs – a company with a higher percentage of fixed costs is said to have “high operating leverage,” because as its sales grow, more of those sales trickle down into operating income.

For example, software companies tend to have high operating leverage because most of their spending happens upfront in the product development process.

Selling each additional copy of a software product costs very little since the distribution is almost free and there are no “raw materials.”

On the other hand, consulting or services companies have low operating leverage because most of their spending is variable: as sales increase, their spending increases in lockstep, and as sales decrease, their spending also decreases.

So the end result is that operating leverage introduces higher potential rewards, but also greater risk.

If a company’s sales increase, it helps to have higher operating leverage. But if they decrease, higher operating leverage hurts them because they won’t be able to reduce spending as quickly.

Operating Leverage Formula Examples

There are several different formulas for calculating operating leverage:

Operating Leverage Formula 1: Fixed Costs / (Fixed Costs + Variable Costs)

The problem with this one is that most companies don’t spell out what is a fixed vs. variable cost in their filings.

Operating Leverage Formula 2: % Change in Operating Income / % Change in Sales

Operating Leverage Formula 3: Net Income / Fixed Costs

Operating Leverage Formula 4: Contribution Margin / Operating Margin

In practice, we tend to use the second formula: the % change in operating income divided by the % change in sales, because it’s the easiest one to apply when you have limited information.

However, the other formulas can be useful if you have additional insight into the company’s fixed vs. variable costs.

How to Interpret Operating Leverage in Real Life

This metric is MOST meaningful when you calculate it for companies in the same industry with roughly the same operating margins.

So it doesn’t make sense to use it to compare a software company to a manufacturing company, or to compare a biotech startup to a mature media company.

As a company’s operating leverage increases, each *percentage* of sales growth will translate into a higher *percentage* of operating income growth.

Consider Company A, with revenue of $1 billion, operating income of $200 million, and operating leverage of 2.0x, and Company B, with revenue of $1 billion, operating income of $200 million, and operating leverage of 1.0x.

“Operating leverage” means that when Company A’s revenue increases by 10%, its operating income will increase by 20%, so it will have operating income of $240 million on revenue of $1.1 billion.

On the other hand, Company B’s operating income will increase by only 10%, so it will rise to $220 million on revenue of $1.1 billion.
In the “Upside” case when sales increase, this is positive because Company A will earn more operating income from those additional sales.

But if sales decrease, Company A is worse off because it can’t cut its expenses to match its falling sales to the same degree that Company B can.

So it’s similar to debt in leveraged buyouts: more debt increases the potential rewards, but also the risk.

On balance, most investors prefer companies with high operating leverage simply because it makes it easier to earn out-sized returns – but it also depends on the investment firm’s strategy, the industry, and the companies involved.

What is the formula for calculating operating leverage?

How to calculate degree of operating leverage from operating leverage?

What is the degree of operating leverage?