It is usually associated with the effect that is created in a business as a result of their fixed costs. These fixed costs cause a leverage effect on earnings before interest and taxes. This is a leverage effect since a variation in sales produces an overly proportional variation in income.
Another way to think about this is that operating leverage is the relationship between fixed costs and variable costs when taking into account that the relationship between the price and the variable costs is called the gross contribution margin = price – total variable costs.
When fixed costs are high (and variable costs are low) a business is said to have a high operating leverage and is considered riskier because they still have to pay off large fixed costs like interest on debt or rent. Conversely, when fixed costs are low (and variable costs are high) a company is said to have a low operating leverage and is considered less risky because if its variable costs are more related to its revenue and, therefore, when there is a drop in revenue, it can still cover the fixed costs because they are low.
But why are these statements true?
Let´s imagine that we´re going to open a new business. To do this it will be necessary to assume the costs of the acquisition of machinery, office furniture, buildings, etc. All of these are called structural costs or, that is to say, fixed costs. The variable costs are relative to the acquisition of materials, resources, services, paying salaries, etc.
Once the business is running, there will be a moment when the fixed costs are covered. At this moment, in which we have hit the break-even point, if there is an increase in sales, this will lead to an increase in a greater proportion in earnings, or the operating leverage effect. Also, it should be noted that with greater fixed costs, it takes longer for a business to reach the break-even point. Let´s think about some more examples related to operating leverage. A business that makes few sales, with each sale providing a very high gross margin, is said to be highly leveraged. A business that makes many sales, with each sale contributing a very slight margin, is said to be less leveraged.
As the volume of sales in a business increases, each new sale contributes less to fixed costs and more to earnings, especially after hitting the break-even point.
So which is better; being more leveraged or less leveraged?
The answer depends on the company itself. If it has the opportunity to invest in a project, machine, infrastructure, etc. that will increase the rate of return to a higher level than the cost of the interest to pay off the debt, it should proceed even though this would raise its DOL degree of operating leverage. For example, convenience stores are significantly less leveraged than high-end car dealerships. Another way to look at operating leverage is at higher degrees of operating leverage, the greater the potential danger from forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be magnified into large errors in cash flow projections.
At the beginning of a business initiative there may be insufficient funds available, so there are two options; postpone the project or ask for a loan, which leads to debt (in other words, financial leverage). The operating leverage will appear afterwards due to the variations in sales, being affected by the contribution margin and the fixed costs.
The degree of operating leverage (DOL) can be calculated in the following ways:
DOL: (% change in EBIT) / (% change in the quantity of sales)
DOL: Quantity of sales (price – Variable cost) / (Quantity of sales (price – Variable cost) – Fixed cost or more simply
DOL: Contribution margin / EBIT, where the Contribution margin = sales – Variable costs and EBIT = Contribution margin – Fixed costs