Operating leverage is the financial efficiency ratio. It is used to measure that how much percentage of total cost made from the fixed cost and variable cost. This calculation finds the efficiency of the company to generate the profit from its fixed cost.
As compare to variable cost if the fixed cost is higher then the leverage ratio of the company is high and the company generates more profit from each incremental sale.
If variable cost is high then the fixed cost, then the company is less leverage and make a small profit from its every incremental sale. In other words, if the ratio is high-cost ratio then the company make a high profit.
Definition: What is Operating Leverage?
For the calculation of Breakeven point and for estimating the effectiveness of pricing structure managers use operating leverage. Due to effective pricing structure, the company may have a high economic gain because the company can control the demand by offering better products at a lower price. For the covering of fixed cost with profit, the company generates adequate sales volume. Whereas for covering the variable cost the company needs to increase its sales.
If the gross margin of the company is high then the company have high DOL ratio. Such type of company can make more money from its incremental revenue. High degree of operating leverage (DOL) incurs higher forecasting risks for the company because with the small mistake in the calculation sales may be lead to large miscalculation of cash flow. So for the company, it is necessary to make the good managerial decisions otherwise company lead to lower sale revenue.
Operating leverage formula can be calculated by multiplying the quantity with the difference between price and variable cost per unit and divided it by multiplying the quantity with the difference between price and variable cost per unit and divided it by multiplying the quantity with the difference between price and variable cost per unit minus fixed operating cost.
Operating Leverage = Quantity x (Price – Variable cost per unit)/Quantity x (Price – Variable cost per unit) -Fixed operating cost
If the above equation breakdown then it shows that the DOL is expressed by relation b/w price and variable cost per unit quantity. In general term, we can write the above equation as
The degree of Operating Leverage = ( Sales – Variable )/Profit
To adjust the pricing structure to the high sales of the firm manager monitor DOL. If there is a small decrease in the sale it may be the cause of a decrease in the profit.
Mic has a leading software business. He mostly incurs the fixed cost for the development and marketing of the business. The fixed cost of Mic is 78,000 dollars which go in the salaries of the developer and cost per unit is 0.08 dollars. For each 25 dollars company sales 300,000 units. In the marketing, sales and development this business involved which have the application, customize software for the enterprises from the network system and operating management tools.
Operating leverage for Mic’s business by using fixed cost and variable cost calculated as
112% = [30,000 x (25 – 0.08)]/ [30,000 x (25 – 0.08)] – 78,000
It means that by increasing the 10% sales profit increase 12%.
For 20 dollars each if the company increase sales to 450,000 units then Dol will be calculated as
110% = [45,000 x (20 – 0.08 )]/ [45,000 x (20 – 0.08 )] -78,000
From the above result, we can say that if we increase 10% in sales then the profit increase by 11%. In sales, the company generates more revenue1,527,000 dollars. So by lowering the price sales revenue increase and cost remain unchanged.
Impact of operating leverage on the EBIT of the firm shown by the degree of the operating leverage. For the assessment of the core operation’s fixed and variable cost of business, DOL is important.
If the company has a high degree of operating leverage then the company has more fixed cost as compare to variable cost. So the business has more fixed assets to support its core business. It also means that the company makes more money from its additional sales by keeping the fixed asset of the company intact. When the company has a high margin with fewer sales it means that the company has high DOL. Without incurring of high costs, the fixed asset of the company acquires higher value as a result. At the end of the day, the profit margin of the firm can expand at a faster rate as compared to sales revenue.
If the company has low DOS it means that the company has less fixed cost as compared to the variable cost. Such type of company useless fixed cost to operate core business activities and has low gross margin.
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