Operation leverage takes into account a company’s fixed costs as a percentage of their total costs. It is usually used for calculating a company’s break-even point on sales
The formula for calculating operating leverage is Contribution Margin/ Net Operating Income. Companies tend to fall into two categories of operating leverage:
- High Operating Leverage – this is a company with high fixed cost relative to their total costs. A company with high operating leverage has low variable costs, so the contribution margin on each unit sold yields relatively high profit for the company. This high profit is then used to pay off the high fixed costs, which means they need a high volume and steady stream of sales to stay profitable. An example of this is a software company. Selling 10 subscriptions vs. 1000 subscriptions has almost no impact on variable costs, but in either scenario the company will still have to pay expensive developer salaries.
- Low Operating Leverage – this is a company where the fixed costs are relatively low, and most of their expenses come from variable costs. A company like this has a smaller contribution margin, but also needs to make fewer volume of sales to be profitable, since they have low fixed costs. An example of a company with a low operating leverage could be an electrician company. When a client needs work, they need to go out and buy supplies to get the job done. The cost of supplies takes a chunk out of the total profit, but the company doesn’t have to worry about a nice big expensive office space in their fixed costs.