Operating Leverage: Calculation and Meaning

You will learn what the concept of “operating leverage” means in this lesson, including several different methods to calculate it and interpret it for real companies. You’ll also learn why it sometimes doesn’t tell you as much as you think it does.
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Table of Contents:
0:57 What Does Operating Leverage Mean?
5:16 Formulas to Calculate Operating Leverage
15:25 How to Interpret Operating Leverage in Real Life
20:21 Recap and Summary
What Does Operating Leverage Mean?
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.
Formulas to Calculate Operating Leverage
There are several different formulas for calculating 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.
Formula 2: % Change in Operating Income / % Change in Sales
Formula 3: Net Income / Fixed Costs
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.
RESOURCES:
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[@oussemaklai]

Thank you for this great tutorial !

[@financialmodeling]

Thanks for watching!

[@MsNancy45]

Really appreciate if you could upload more video!

[@financialmodeling]

Luisa Lui There are thousands of videos in our online courses. We do share a good number here, but we're never going to publicly post everything or more than ~10% or so of what is available to our customers. We generally upload 2-3 new lessons per month.

[@mohammedsindi761]

Thank you for the great video!! But what is the interpretation if we get a negative operating leverage?

[@financialmodeling]

It just means the company's operating income will fall proportionally more than revenue when there's a decrease in revenue. This is generally seen as a negative, but, again, it depends on the business model and company.

[@doannguyenduc5664]

I saw the formula Net Income/Fixed Costs to get the DOL. I couldn't find this formula anywhere else. Could you please explain it to me?

[@financialmodeling]

Sorry, I'm not sure about that one. I would net to see an example to say anything useful - as we don't normally define Operating Leverage like that.

[@doannguyenduc5664]

Sir, I saw that formula in this video.

[@financialmodeling]

@@doannguyenduc5664 It is mentioned briefly on one of the slides here, but we don't use it in the Excel file or recommend using it, as it makes less sense than the others. I don't recall exactly where we found this reference because this video is from ~8 years ago, but a book or textbook must have included it somewhere. But I would not worry about this at all since it's not used much, if at all, in real life.

[@doannguyenduc5664]

Thank you so much!

[@johnyy5563]

I want to ask that if the company revenue grow to estimately 59%
It is possible the company profit going grow to? And it true that the company percentage of operating income going lower that the % of sale if the company have a lower operating leverage?

[@financialmodeling]

It's impossible to say without more information. What are the company's current margins? What is its cost structure? What is its industry and maturity stage? Just knowing the revenue growth is not enough. Lower operating margins don't necessarily mean lower operating leverage... you need to look at the breakout between fixed and variable costs.

[@cantbeanelegbede]

great video totally learned much thanks

[@financialmodeling]

Sunflower47 Thanks for watching!

[@aktiecase]

Great video! Cheers

[@financialmodeling]

Thanks for watching!

[@enricocoleman7834]

Thank you for the great help 👍🏼

[@financialmodeling]

Thanks for watching!

[@francescamichelini4833]

Very useful. Great.

[@johnyy5563]

And also how to describe a lower operating leverage company managed to increase its income so much with a 50% increase in sales?

[@financialmodeling]

Maybe by reducing its fixed or variable costs, changing the ratio of those costs, getting rid of lower-performing groups or divisions, or something else like that. There could be dozens of reasons.

[@MrSifaperdire]

Thanks

[@financialmodeling]

Thanks for watching!

[@akmaroma]

really useful video.thanks for sharing.

[@financialmodeling]

Thanks for watching!