What is operating leverage in financial management is a very common query for all the business owners out there. In theoretical terms, operating leverage is a breakdown and analysis of the fixed and the variable costs and is a key instrument in financial management. It primarily helps understand how effectively you are making use of fixed costs to generate profit. A higher operating leverage ratio means that a company has higher fixed costs than variable costs. In other words, higher variable costs would mean a lower operating ratio, which in turn would lower profit.
The operating leverage equation in financial management is a very crucial tool that helps calculate your company’s breakeven point and discover how much your company can increase its operating income by raising revenue. It helps companies make an effective pricing structure, which in turn would allow them to control demand by reducing the price of the product. While adequate sales can help cover fixed costs, in order to cover variable costs, there has to be a trend of incremental sales.
Understanding the formula of DOL (Degree of Operating Leverage)
The DOL can be calculated using the formula:
Operating Leverage= (Quantity x (Price – Variable Cost Per Unit)) / ((Quantity x (Price – Variable Cost Per Unit)) – Fixed Operating Costs)
To make it simpler, you could even use the formula:
Operating Leverage = (Sales – Variable Costs) / Profits
For maximum benefit, managers need to steer their pricing structure to incorporate higher sales as a small impact on sales can have a huge impact on the profits. Let’s take an example for your better understanding.
Let’s assume a company incurs fixed costs worth Rs. 6,00,000 and the cost per unit is Rs. 0.20. The company sells 5,50,000 units for Rs. 40 each. Based on the above costs, the DOL would be calculated as follows:
Operating Leverage= (5,50,000 x (40-0.20))/ (5,50,000 x (40-0.20) – 6,00,000)
To interpret this number, it means that a 10% increase in sales would mean a 10.2% increase in revenue.
Which is better – high or low operating leverage ratio?
In general terms, high operating leverage is preferable over low operating leverage as it would allow you to generate better and higher profits on each additional sale. But on the other hand, a lower operating leverage ratio would mean a lower amount of sales, or in other words, earning profit would be easier. Sound financial advice states that the higher the degree of leverage, forecasting becomes more dangerous as a slight error in forecasting could lead to a huge problem. Additionally, macroeconomic conditions also have a huge impact on the DOL. When the economy is in good shape, you will experience an increase in profitability, but when the conditions are bad, you will see an increase in costs and thereby experience lower profitability.
While both have their advantages and disadvantages, it is entirely upon you and the nature of your business to decide whether a high or low DOL will be beneficial for you.
The DOL shows the impact of operating leverage on a firm’s EBIT, i.e Earning Before Taxes. It reveals the risk quotient of a company to its stakeholders. From an investor’s point of view, calculating operating leverage could help you to analyse the financial health of a company, influencing your decision of stocks to buy today.
When it comes to making mutual fund investment decision or investing in the stock market, it is crucial to get all the jargon and formula right. It is even wiser to reach out to a financial expert before taking such major decisions. An expert can suggest suitable investment avenues for you like mutual funds, fixed deposits, Exchange Traded Funds, etc., based on your risk tolerance, investment horizon, financial goals and age.
- What is the importance of operating leverage?
Operational leverage helps you determine the optimal pricing point that will allow you to break even by covering all of your costs and generating a profit. Additionally, it helps make the right mix between fixed and variable assets for optimum profits.
- How is risk linked with operating leverage?
Higher amounts of fixed assets in the business mean higher operating leverage. It usually easily translates into higher risk with less control over demand and price. When the DOL is higher, a minute error in forecasting could lead to massive errors in cash flow.
- What is the ideal DOL?
A DOL of 0.5 is ideal, but it almost entirely depends on the nature of the business.