![]() “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. 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.Īs a company’s operating leverage increases, each *percentage* of sales growth will translate into a higher *percentage* of operating income growth.Ĭonsider 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. This metric is MOST meaningful when you calculate it for companies in the same industry with roughly the same operating margins. How to Interpret Operating Leverage in Real Life However, the other formulas can be useful if you have additional insight into the company’s fixed vs. 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. ![]() ![]() Operating Leverage Formula 4: Contribution Margin / Operating Margin Operating Leverage Formula 3: Net Income / Fixed Costs Operating Leverage Formula 2: % Change in Operating Income / % Change in Sales The problem with this one is that most companies don’t spell out what is a fixed vs. Operating Leverage Formula 1: Fixed Costs / (Fixed Costs + Variable Costs) There are several different formulas for calculating operating leverage: But if they decrease, higher operating leverage hurts them because they won’t be able to reduce spending as quickly. If a company’s sales increase, it helps to have higher operating leverage. So the end result is that operating leverage introduces higher potential rewards, but also greater risk. 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. Selling each additional copy of a software product costs very little since the distribution is almost free and there are no “raw materials.” 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.įor example, software companies tend to have high operating leverage because most of their spending happens upfront in the product development process. Operating leverage relates to a company’s fixed vs.
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