OPERATING LEVERAGE

COST ACCOUNTING
INSTRUCTOR: MEHNAZ KHAN
Operating leverage is a cost-accounting formula that measures the
degree to which a firm or project can increase operating income
by increasing revenue. A business that generates sales with a high
gross margin and low variable costs has high operating leverage.
•If a company has high operating leverage, each additional dollar of revenue
can potentially be brought in at higher profits after the break-even point has been
exceeded. Thus, each marginal unit is sold at a lesser cost, creating the potential for
greater profitability since fixed costs such as rent and utilities remain the same
regardless of output.

•If a company has low operating leverage (i.e., greater variable costs), each
additional dollar of revenue can potentially generate less profit as costs increase in
proportion to the increased revenue. Here, as more revenue is produced, the growth
in the variable costs offsets the additional revenue and limits the company’s capacity
to endure periods of lackluster sales performance (i.e., sustain its profit margins to stay
in line with historical levels).
When a company’s revenue increases, having a high degree of leverage tends
to be beneficial to its profit margins

However, if revenue declines, the leverage can end up being detrimental to the
margins of the company because the company is restricted in its ability to
implement potential cost-cutting measures.
In a high operating leverage situation, a large proportion of the company’s
costs are fixed costs. In this case, the firm earns a large profit on each
incremental sale, but must attain sufficient sales volume to cover its
substantial fixed costs. If it can do so, then the entity will earn a major profit
on all sales after it has paid for its fixed costs. However, earnings will be
more sensitive to changes in sales volume.

In a low operating leverage situation, a large proportion of the company’s

sales are variable costs, so it only incurs these costs when there is a sale. In
this case, the firm earns a smaller profit on each incremental sale, but does
not have to generate much sales volume in order to cover its lower fixed
costs. It is easier for this type of company to earn a profit at low sales levels,
but it does not earn outsized profits if it can generate additional sales.