Operating leverage what is

But thanks to the internet, Inktomi's software could be distributed to customers at almost no cost. In other words, the company had close to zero cost of goods sold. After its fixed development costs were recovered, each additional sale was almost pure profit. After the collapse of dotcom technology market demand in , Inktomi suffered the dark side of operating leverage. The high leverage involved in counting on sales to repay fixed costs can put companies and their shareholders at risk.

High operating leverage during a downturn can be an Achilles heel, putting pressure on profit margins and making a contraction in earnings unavoidable. Indeed, companies such as Inktomi, with high operating leverage, typically have larger volatility in their operating earnings and share prices.

As a result, investors need to treat these companies with caution. Operating leverage occurs when a company has fixed costs that must be met regardless of sales volume. When the firm has fixed costs, the percentage change in profits due to changes in sales volume is greater than the percentage change in sales.

With positive i. A measure of this leverage effect is referred to as the degree of operating leverage DOL , which shows the extent to which operating profits change as sales volume changes. This indicates the expected response in profits if sales volumes change. Specifically, DOL is the percentage change in income usually taken as earnings before interest and tax , or EBIT divided by the percentage change in the level of sales output.

Sales volume reaches one million copies. So, the software company enjoys a DOL of 1. Unfortunately, unless you are a company insider , it can be very difficult to acquire all of the information necessary to measure a company's DOL. Consider, for instance, fixed and variable costs, which are critical inputs for understanding operating leverage. It would be surprising if companies didn't have this kind of information on cost structure, but companies are not required to disclose such information in published accounts.

Investors can come up with a rough estimate of DOL by dividing the change in a company's operating profit by the change in its sales revenue.

Looking back at a company's income statements , investors can calculate changes in operating profit and sales. Investors can use the change in EBIT divided by the change in sales revenue to estimate what the value of DOL might be for different levels of sales. This allows investors to estimate profitability under a range of scenarios.

Software can do the math for you. Be very careful using either of these approaches. They can be misleading if applied indiscriminately. They do not consider a company's capacity for growing sales. Few investors really know whether a company can expand sales volume past a certain level without, say, sub-contracting to third parties or making further capital investment, which would increase fixed costs and alter operational leverage. At the same time, a company's prices, product mix and cost of inventory and raw materials are all subject to change.

Without a good understanding of the company's inner workings, it is difficult to get a truly accurate measure of the DOL. In finance, companies assess their business risk by capturing a variety of factors that may result in lower-than-anticipated profits or losses. One of the most important factors that affect a company's business risk is operating leverage; it occurs when a company must incur fixed costs during the production of its goods and services.

A higher proportion of fixed costs in the production process means that the operating leverage is higher and the company has more business risk. When a firm incurs fixed costs in the production process, the percentage change in profits when sales volume grows is larger than the percentage change in sales. When the sales volume declines, the negative percentage change in profits is larger than the decline in sales. Operating leverage reaps large benefits in good times when sales grow, but it significantly amplifies losses in bad times, resulting in a large business risk for a company.

Although you need to be careful when looking at operating leverage, it can tell you a lot about a company and its future profitability, and the level of risk it offers to investors.

While operating leverage doesn't tell the whole story, it certainly can help. Securities and Exchange Commission. Accessed May 13, Financial Ratios.

Investing Essentials. Financial Analysis. With each dollar in sales earned beyond the break-even point, the company makes a profit. Conversely, retail stores tend to have low fixed costs and large variable costs, especially for merchandise. Because retailers sell a large volume of items and pay upfront for each unit sold, COGS increases as sales increase. Because of this, such stores often have low operating leverage.

Investing Essentials. Financial Ratios. Financial Analysis. Actively scan device characteristics for identification. Use precise geolocation data. Select personalised content. Create a personalised content profile. Measure ad performance. Select basic ads. Create a personalised ads profile. Select personalised ads. Apply market research to generate audience insights.

Measure content performance. Develop and improve products. List of Partners vendors. Your Money. Personal Finance. Your Practice. Popular Courses. Financial Ratios Guide to Financial Ratios. In other words, high fixed costs means a higher leverage ratio that turn into higher profits as sales increase.

This is the financial use of the ratio, but it can be extended to managerial decision-making. An effective pricing structure can lead to higher economic gains because the firm can essentially control demand by offering a better product at a lower price.

If the firm generates adequate sales volumes, fixed costs are covered, thereby leading to a profit. However, to cover for variable costs, a firm needs to increase its sales.

If a firm generates a high gross margin , it also generates a high DOL ratio and can make more money from incremental revenues. This happens because firms with high degree of operating leverage DOL do not increase costs proportionally to their sales. On the other hand, a high DOL incurs a higher forecasting risk because even a small forecasting error in sales may lead to large miscalculations of the cash flow projections.

The operating leverage formula is calculated by multiplying the quantity by the difference between the price and the variable cost per unit divided by the product of quantity multiplied by the difference between the price and the variable cost per unit minus fixed operating costs.

By breaking down the equation, you can see that DOL is expressed by the relationship between quantity, price and variable cost per unit to fixed costs. If operating income is sensitive to changes in the pricing structure and sales, the firm is expected to generate a high DOL and vice versa.