what is operating leverage 
operating leverage is a cost accounting formula a financial ratio 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 investopedia nono floresunderstanding operating leveragethe higher the degree of operating leverage the greater the potential danger from forecasting risk in which a relatively small error in forecasting sales can be magnified into large errors in cash flow projections degree of operating leverage contribution margin profit text degree of operating leverage frac text contribution margin text profit degree of operating leverage profitcontribution margin this can be restated as degree of operating leverage q c m q c m fixed operating costs where q unit quantity c m contribution margin price variable cost per unit begin aligned text degree of operating leverage frac q cm q cm text fixed operating costs textbf where q text unit quantity cm text contribution margin price variable cost per unit end aligned degree of operating leverage q cm fixed operating costsq cm where q unit quantitycm contribution margin price variable cost per unit the operating leverage formula is used to calculate a company s break even point and help set appropriate selling prices to cover all costs and generate a profit the formula can reveal how well a company uses its fixed cost items such as its warehouse machinery and equipment to generate profits the more profit a company can squeeze out of the same amount of fixed assets the higher its operating leverage one conclusion companies can learn from examining operating leverage is that firms that minimize fixed costs can increase their profits without making any changes to the selling price contribution margin or the number of units they sell example of operating leveragefor example company a sells 500 000 products for a unit price of 6 each the company s fixed costs are 800 000 it costs 0 05 in variable costs per unit to make each product calculate company a s degree of operating leverage as follows 500 000 6 00 0 05 500 000 6 00 0 05 800 000 2 975 000 2 175 000 1 37 or 137 begin aligned frac 500 000 left 6 00 0 05 right 500 000 left 6 00 0 05 right 800 000 frac 2 975 000 2 175 000 1 37 text or 137 end aligned 500 000 6 00 0 05 800 000500 000 6 00 0 05 2 175 000 2 975 000 1 37 or 137 a 10 revenue increase should result in a 13 7 increase in operating income 10 x 1 37 13 7 high and low operating leverageit is important to compare operating leverage between companies in the same industry as some industries have higher fixed costs than others the concept of a high or low ratio is then more clearly defined most of a company s costs are fixed costs that recur each month such as rent regardless of sales volume as long as a business earns a substantial profit on each sale and sustains adequate sales volume fixed costs are covered and profits are earned other company costs are variable costs that are only incurred when sales occur this includes labor to assemble products and the cost of raw materials used to make products some companies earn less profit on each sale but can have a lower sales volume and still generate enough to cover fixed costs one concept positively linked to operating leverage is capacity utilization which is how much the company uses its resources to generate revenues increasing utilization infers increased production and sales thus variable costs should rise if fixed costs remain the same a firm will have high operating leverage while operating at a higher capacity for example a software business has greater fixed costs in developers salaries and lower variable costs in software sales as such the company has high operating leverage in contrast a computer consulting firm charges its clients hourly and doesn t need expensive office space because its consultants work in clients offices this results in variable consultant wages and low fixed operating costs the business thus has low operating leverage most of microsoft s costs are fixed such as expenses for upfront development and marketing with each dollar in sales earned beyond the break even point the company makes a profit but microsoft has high operating leverage conversely walmart retail stores have low fixed costs and large variable costs especially for merchandise because walmart sells a huge volume of items and pays upfront for each unit it sells its cost of goods sold increases as sales increase because of this walmart stores have low operating leverage 