Operating leverage

Definition

Operating leverage measures how a company's operating income changes with respect to sales volume changes. It indicates the proportion of fixed costs in a company's cost structure, impacting profitability.

5 Must Know Facts For Your Next Test

1. High operating leverage means a company has high fixed costs relative to variable costs.
2. A company with high operating leverage will experience larger changes in operating income with sales volume fluctuations.
3. Operating leverage is calculated as Contribution Margin divided by Net Operating Income.
4. Firms with low operating leverage have more variable costs and are less sensitive to changes in sales volume.
5. Understanding operating leverage helps managers make decisions about cost structure, pricing, and production levels.

Review Questions

• What does a high degree of operating leverage imply about a company's cost structure?
• How is operating leverage calculated?
• Why is understanding operating leverage important for managerial decision-making?

Related terms

Contribution Margin: The amount remaining from sales revenue after variable expenses have been deducted.

Fixed Costs: Costs that do not change with the level of production or sales volume.

Variable Costs: Costs that vary directly with the level of production or sales volume.