Operating Leverage Calculator

Calculate the impact of fixed costs on a company's profitability.

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What is Operating Leverage?

Operating leverage measures how changes in a company’s sales affect its earnings before interest and taxes (EBIT).

Operating leverage is calculated as the percentage change in EBIT divided by the percentage change in sales, showing profit sensitivity to sales changes. It’s important for businesses to understand how fixed costs impact profitability and risk.

High operating leverage means more fixed costs relative to variable costs, leading to faster profit increases when sales rise, but quicker losses when sales fall. For example, software companies often have high operating leverage due to high development costs but low per-sale costs. Retail stores typically have lower operating leverage as costs change more with each sale.

Operating leverage informs decisions on equipment investment, pricing, and risk management, particularly when planning for various economic scenarios.

Operating Leverage Formula

\begin{gather*}\bold{Given{:}}\newline\begin{aligned}\text{Change in EBIT} &= \mathrm{\Delta EBIT}\newline\text{Change in Sales} &= \mathrm{\Delta S}\end{aligned}\newline\bold{Calculate{:}}\newline\text{Operating Leverage} = \mathrm{OL} \newline = \frac{\mathrm{\Delta EBIT}}{\mathrm{\Delta S}}\end{gather*}

Operating Leverage Calculation Examples

Example 1

Consider a software company that shifts from selling perpetual licenses to a subscription model.

As a result, their EBIT increases from $5 million to $6.5 million (up by 30%) when their sales increase from $20 million to $22 million (up by 10%).

The degree of operating leverage in this scenario is:

\begin{gather*}\bold{Given{:}}\newline\begin{aligned}\text{Change in EBIT}\space(\mathrm{\Delta EBIT}) &= \mathrm{30{\%}}\newline\text{Change in Sales}\space(\mathrm{\Delta S}) &= \mathrm{10{\%}}\end{aligned}\newline\bold{Calculate{:}}\newline\text{Operating Leverage}\space(\mathrm{OL})\newline\begin{aligned}&= \frac{\mathrm{\Delta EBIT}}{\mathrm{\Delta S}}\newline&= \frac{\mathrm{30{\%}}}{\mathrm{10{\%}}}\newline&= 3\end{aligned}\end{gather*}

This high operating leverage of 3 indicates that the company's new subscription model has significantly increased their profitability relative to sales growth.

It suggests that the company has high fixed costs (e.g., software development) but low variable costs for each new subscription, allowing for substantial profit increases as sales grow.

Example 2

Imagine a renewable energy company that invests heavily in wind turbine infrastructure.

After expanding their wind farm, their EBIT increases from $8 million to $9.6 million (up by 20%) when their energy production and sales increase from 100 GWh to 115 GWh (up by 15%).

Let's calculate the degree of operating leverage:

\begin{gather*}\bold{Given{:}}\newline\begin{aligned}\text{Change in EBIT}\space(\mathrm{\Delta EBIT}) &= \mathrm{20{\%}}\newline\text{Change in Sales}\space(\mathrm{\Delta S}) &= \mathrm{15{\%}}\end{aligned}\newline\bold{Calculate{:}}\newline\text{Operating Leverage}\space(\mathrm{OL})\newline\begin{aligned}&= \frac{\mathrm{\Delta EBIT}}{\mathrm{\Delta S}}\newline&= \frac{\mathrm{20{\%}}}{\mathrm{15{\%}}}\newline&= 1.333\end{aligned}\end{gather*}

This relatively low operating leverage of 1.333 reflects the high fixed-cost nature of renewable energy.

Substantial investment in wind turbines allows for significant profit growth as energy production increases, with minimal variable costs.

While advantageous during growing energy demand, it also poses risks if demand decreases.

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