Published: 07th Oct 2024
By: Value Research
Ever noticed how some businesses cite operating leverage as a factor behind increase in operating profit margins? But what exactly is operating leverage? And is it a good thing? Let’s break it down:
Operating leverage measures how profits react to changes in revenue or sales. If a company has high fixed costs (like rent, or machinery), it has high operating leverage. This can be good because when sales rise, profits soar faster as fixed costs remain constant.
But if sales drop, profits can fall by a greater magnitude as those fixed costs still need to be paid. It’s like a lever: the more fixed costs a company has, the bigger the effect on profits when sales change.
Companies with low fixed costs and more variable costs have low operating leverage. Which means their profits move steadily with sales because most of their costs are tied directly to how much they sell.
Divide the percentage change in operating profit (EBIT) by percentage change in sales. For example, an operating leverage of 2 means profits will rise twice as fast as sales growth.
Operating leverage is a double-edged sword. It can magnify profits during growth but also magnify losses during downturns. So, always check how much of a company’s costs are fixed. Our story explains the concept using Ultratech Cement’s example. Read it from the link below.