Lesson 34 - Intermediate Accounting Course 

34. Understanding Operating Leverage and Its Impact on Profits

Operating leverage is a key concept in financial analysis that explains how fixed and variable costs impact a company’s profitability. A business with high operating leverage can experience large profit swings with small changes in sales, while a company with low operating leverage has more stable but lower profit margins.

1️⃣ What Is Operating Leverage?

Operating leverage measures how a company’s fixed costs influence its ability to generate profits.

✔ Companies with high fixed costs (e.g., rent, salaries, machinery) have high operating leverage.
✔ Companies with low fixed costs (and higher variable costs) have low operating leverage.

A company with high operating leverage magnifies profits when sales increase but also magnifies losses when sales decline.

Formula for Operating Leverage

Where:
✔ Contribution Margin = Total Revenue – Variable Costs
✔ Net Operating Income = Operating Profit (Revenue – Fixed Costs – Variable Costs)

This ratio shows how sensitive a company's profit is to a change in sales.

2️⃣ High vs. Low Operating Leverage

✔ High Operating Leverage

• Fixed costs are high, variable costs are low
  
  

• Profits grow quickly when sales increase
  
  

• Break-even point is higher (more sales are needed to cover costs)
  
  

• Risky in downturns (profits drop sharply if sales decline)
  
  

• Common in manufacturing, SaaS, airlines, and telecom
  
  

Example: A software company has high fixed costs (development, licensing) but low variable costs (each additional software sale costs very little). This means once the break-even point is reached, profits rise exponentially with sales.

✔ Low Operating Leverage

• Fixed costs are low, variable costs are high
  
  

• Profits grow slowly with sales increases
  
  

• Lower break-even point (less risky)
  
  

• More flexible in downturns
  
  

• Common in retail, restaurants, and service-based businesses
  
  

Example: A consulting firm pays consultants per project (variable cost). If demand falls, it can simply reduce its workforce, keeping costs aligned with revenue.

3️⃣ The Impact of Operating Leverage on Profits

Operating leverage determines how much a company benefits from increased sales.

✔ Scenario: Company A (High Operating Leverage) vs. Company B (Low Operating Leverage)

Now, if both companies increase sales by 20% (to 3,600 units), here’s what happens:

• Company A’s profit jumps from $20,000 to $50,000 (150% increase!)
  
  

• Company B’s profit rises only from $30,000 to $42,000 (40% increase)
  
  

This shows that high operating leverage magnifies profits when sales grow.

However, in a sales decline, Company A would suffer a bigger loss than Company B.

4️⃣ The Break-Even Point and Operating Leverage

A company with high fixed costs needs more sales to reach profitability.

✔ Higher fixed costs = Higher break-even sales
✔ Lower fixed costs = Lower break-even sales

Example:

• A high-operating-leverage company might break even at 5,000 units
  
  

• A low-operating-leverage company might break even at 2,000 units
  
  

The risk? If demand drops below the break-even point, a company with high operating leverage suffers greater losses.

5️⃣ Practical Applications of Operating Leverage

✔ 1. Business Expansion Decisions

A company considering automation (machines) vs. manual labor (workers) should analyze operating leverage:

• More automation → Higher fixed costs → Higher leverage
  
  

• More manual labor → Lower fixed costs → Lower leverage
  
  

If sales are expected to rise, automation (high leverage) is beneficial. If sales are uncertain, lower leverage is safer.

✔ 2. Industry Comparisons

• Tech & manufacturing firms rely on high leverage (big upfront costs, low variable costs).
  
  

• Retail & food services have low leverage (low fixed costs, flexible expenses).
  
  

✔ 3. Financial Risk Assessment

Investors use operating leverage to assess a company’s risk and profitability potential. A firm with high operating leverage is riskier but offers higher returns when successful.

6️⃣ Summary & Key Takeaways

✔ Operating leverage shows how fixed costs impact profits as sales change.
✔ High operating leverage = High risk, high reward (big profits in good times, big losses in bad times).
✔ Low operating leverage = More stable but lower profits.
✔ Companies with high fixed costs must sell more to break even, but once past that point, they earn more per unit.
✔ CVP analysis helps determine the optimal level of operating leverage for a business.

Businesses should carefully balance fixed and variable costs based on their industry, growth potential, and risk tolerance.