Student Question

What does operating leverage measure, and how is it computed?

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Operating leverage is used to determine how a change in sales revenue affects the operating income of a company.

There are many ways of finding operating leverage. One of them is to denote it by ratio of the contributing margin ratio and the operating margin. This is called the degree of leverage or DOL.

DOL = contributing margin ratio/operating margin

Contributing margin ratio is the ratio of total revenue - total variable cost to total revenue. And operating margin is the ratio of operating income to total revenue. DOL is also the ratio of the change in operating income to the change in revenue.

As an example, if a company has a degree of leverage which is 1.5, this would mean a 15% increase in operating income for a 10% increase in sales revenue, but it also might indicate operating income falling by 15% for a 10% fall in revenue.

The degree of leverage is higher when fixed costs are higher and variable costs lower. This would be the case if production is automated by using advanced machinery. This is also the case when fixed expenditure on marketing, research, etc. is higher.

To ensure an appropriate operating income it is essential for companies to strike a right balance between the total costs and variable costs involved in creating what they sell.

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What does operating leverage measure?

In business, the term "leverage" refers to the amount of debt that a firm has.  The term refers to the idea that the firm is using the debt as a lever to allow it to use a little debt to make large profits.

Operating leverage is a measure of how much of a firm's costs are fixed, as opposed to variable.  A firm has higher operating leverage if many of its costs are fixed.  Fixed costs are costs like machinery--things that cost a certain amount, regardless of how much product a firm produces.  A firm with high operating leverage is in a relatively good position because any increases in its level of production bring it more profits because so many of its costs are fixed.

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