Companies with large amounts of fixed costs will generally have a high operating leverage.

Operating leverage, in simple terms, is the relationship between fixed and variable costs. Fixed costs are costs that are incurred regardless of the number of units sold. Variable costs change with the level of sales. A company with high operating leverage has a high percentage of fixed costs to total costs, which means more units have to be sold to cover costs. A company with low operating leverage has a high percentage of variable costs to total costs, which means fewer units have to be sold to cover costs. In general, a higher operating leverage leads to lower profits.

What Profit Is

Profit is defined as the difference between revenues and costs. If sales are $10,000 and costs are $5,000, the profit is $5,000. So, the two main variables in profit are sales and costs. In general, the more you can sell, the more profit you make. Likewise, the lower your costs, the more profit you will have. Operating leverage helps small-business owners understand and minimize the effect that cost structure has on company profits, suggests Biz Filings.

Understanding Cost Structures

The more operating leverage a company has, the more it has to sell before it can make a profit. In other words, a company with a high operating leverage must generate a high number of sales to cover high fixed costs, and as these sales increase, so does the profitability of the company. Conversely, a company with a lower operating leverage will not see a dramatic improvement in profitability with higher volume, because variable costs, or costs that are based on the number of units sold, increase with volume.

Operating Leverage and Its Implications

Operating leverage defines a company's break-even point, reports Accounting Tools. The break-even point is the point at which costs are equal to sales; the company "breaks even" when the cost to produce a product equals the price customers pay for it.

The importance of operating leverage is that it drives a company's pricing strategy. To make a profit, the price must be higher than the break-even point. A company with a high operating leverage, or a higher ratio of fixed costs to variable costs, always has a higher break-even point than a company with a low operating leverage. The company with a high operating leverage, all other things being equal, must raise prices to make a profit.

Benefits to High Fixed Costs

It may seem as though a low operating leverage is beneficial to profits, but a high fixed cost leverage structure also has some benefits. The principal advantage is that companies with a high operating leverage have more to gain from each additional sale because they don't have to increase costs to generate more sales. As a result, profit margins increase at a faster pace than sales. For example, most software and pharmaceutical companies invest a large amount in upfront development and marketing. It doesn't matter if Microsoft or Pfizer sell one unit or 100 units, as their fixed costs will not change much.

Question: Describing an organization’s cost structure helps us to understand the amount of fixed and variable costs within the organization. What is meant by the term cost structure?

Answer: Cost structureThe proportion of fixed and variable costs to total costs. is the term used to describe the proportion of fixed and variable costs to total costs. For example, if a company has $80,000 in fixed costs and $20,000 in variable costs, the cost structure is described as 80 percent fixed costs and 20 percent variable costs.

Question: Operating leverageThe level of fixed costs within an organization. refers to the level of fixed costs within an organization. How do we determine if a company has high operating leverage?

Answer: Companies with a relatively high proportion of fixed costs have high operating leverage. For example, companies that produce computer processors, such as NEC and Intel, tend to make large investments in production facilities and equipment and therefore have a cost structure with high fixed costs. Businesses that rely on direct labor and direct materials, such as auto repair shops, tend to have higher variable costs than fixed costs.

Operating leverage is an important concept because it affects how sensitive profits are to changes in sales volume. This is best illustrated by comparing two companies with identical sales and profits but with different cost structures, as we do in . High Operating Leverage Company (HOLC) has relatively high fixed costs, and Low Operating Leverage Company (LOLC) has relatively low fixed costs.

Figure 6.7 Operating Leverage Example

One way to observe the importance of operating leverage is to compare the break-even point in sales dollars for each company. HOLC needs sales of $375,000 to break even (= $300,000 ÷ 0.80), whereas LOLC needs sales of $166,667 to break even (= $50,000 ÷ 0.30).

Question: Why don’t all companies strive for low operating leverage to lower the break-even point?

Answer: In , LOLC looks better up to the sales point of $500,000 and profit of $100,000. However, once sales exceed $500,000, HOLC will have higher profit than LOLC. This is because every additional dollar in sales will provide $0.80 in profit for HOLC (80 percent contribution margin ratio), and only $0.30 in profit for LOLC (30 percent contribution margin ratio). If a company is relatively certain of increasing sales, then it makes sense to have higher operating leverage.

Financial advisers often say, “the higher the risk, the higher the potential profit,” which can also be stated as “the higher the risk, the higher the potential loss.” The same applies to operating leverage. Higher operating leverage can lead to higher profit. However, high operating leverage companies that encounter declining sales tend to feel the negative impact more than companies with low operating leverage.

To prove this point, let’s assume both companies in experience a 30 percent decrease in sales. HOLC’s profit would decrease by $120,000 (= 30 percent × $400,000 contribution margin) and LOLC’s profit would decrease by $45,000 (= 30 percent × $150,000 contribution margin). HOLC would certainly feel the pain more than LOLC.

Now assume both companies in experience a 30 percent increase in sales. HOLC’s profit would increase by $120,000 (= 30 percent × $400,000 contribution margin) and LOLC’s profit would increase by $45,000 (= 30 percent × $150,000 contribution margin). HOLC benefits more from increased sales than LOLC.

Key Takeaway

• The cost structure of a firm describes the proportion of fixed and variable costs to total costs. Operating leverage refers to the level of fixed costs within an organization. The term “high operating leverage” is used to describe companies with relatively high fixed costs. Firms with high operating leverage tend to profit more from increasing sales, and lose more from decreasing sales than a similar firm with low operating leverage.

Review Problem 6.5

What are the characteristics of a company with high operating leverage, and how do these characteristics differ from those of a company with low operating leverage?

Solution to Review Problem 6.5

Companies with high operating leverage have a relatively high proportion of fixed costs to total costs, and their profits tend to be much more sensitive to changes in sales than their low operating leverage counterparts. Companies with low operating leverage have a relatively low proportion of fixed costs to total costs, and their profits tend to be much less sensitive to changes in sales than their high operating leverage counterparts.

Does higher fixed costs mean higher operating leverage?

What happens to operating leverage when fixed costs increase?

When a company has high operating leverage?

What types of companies are more likely to have high leverage?