Operating Leverage Calculation: Numerical Examples

 

Introduction

Operating leverage is a good indicator of the effect of the firm’s variable and fixed costs to its profitability as the sales volume goes up. Seeing operating leverage by means of numerical lessons will assist students and working people to understand its practical effects better. Royal Research is a company that offers detailed academic writing services in finance subject to enhance their performance in their assignments. In this article, we will use practical examples of operating leverage to demonstrate how it affects the performance of the business.

What is Operating Leverage?

The Operating Leverage reflects the ability of a company’s operating income to react to fluctuations in sales volume. Fixed cost proportion in operating expenses is higher for companies with high operating leverage as they are more sensitive to sales.

Calculating Operating Leverage

The formula for operating leverage is:

Operating Leverage= (%change in Operating Income) / (%change in Sales)

Alternatively, it can be expressed using the contribution margin and operating margin:

Operating Leverage =% of Contribution Margin / % of Operating Margin

Numerical Example 1:

Scenario:

Revenue: $1,000,000

Variable Costs: $600,000

Fixed Costs: $200,000

Step-by-Step Calculation:

Calculate Contribution Margin:

Contribution Margin= (Revenue−Variable Costs)/Revenue

Contribution Margin= ($1,000,000- $600,000)/1,000,000

Contribution Margin=0. 4 or 40%

Calculate Operating Margin:

Operating Margin= (Revenue−Variable Costs−Fixed Costs)/Revenue

Operating Margin= (1,000,000−600,000−200,000)/1,000,000

Operating Margin= 2 or 20%

Calculate Operating Leverage:

Operating Leverage =% of Contribution Margin / % of Operating Margin

Operating Leverage=(40/20)=2

Interpretation:

Every 1% increase in sales make operating income increase by 2%. This implies that the level of the operating leverage for the company is moderate, which means that the company is sensitive to variations in the volume of sales.

 

Numerical Example 2:

Scenario:

Revenue Year 1: $800,000

Revenue Year 2: $1,000,000

Variable Costs: 60% of the revenue

Fixed Costs: $200,000

Step-by-Step Calculation:

Calculate Initial Operating Income:

Year1, Variable Costs=0.6×800,000=480,000

Year 1, Operating Income=800,000−480,000−200,000=120,000

Calculate New Operating Income:

Year 2, Variable Costs=0.6×1,000,000=600,000

Year 2, Operating Income=1,000,000−600,000−200,000=200,000

Calculate Percentage Change in Sales and Operating Income: 

%Change in Sales= (1,000,000−800,000)/800,000×100=25%

%Change in Operating Income= (200,000−120,000)/120,000×100=66.67

Calculate Operating Leverage: 

Operating Leverage= (%Change in Operating Income)/ (%Change in Sales)

Operating Leverage=66.67/25=2.67

Interpretation: Hence, a greater degree of operating leverage 2.67 shows that operating profit of the company is highly sensitive to even small changes in volume of sales. The 25% rise of sales resulted in 66% of the rise. 67% increase in operating income shows that the fixed cost margin is an important element of profit margins.

Conclusion

It is essential to have an understanding of operating leverage and its calculation in order to have a good financial management and a strategic planning. The operating leverage has been demonstrated mathematically using the numerical examples below. This is to enable firms to weigh the risks involved in sales and in making decisions. We at Royal Research are committed to creating an environment where students can learn the intricacies of financial concepts through our academic writing service. When it comes to essays, dissertations, assignments, reports, or case studies, our experienced experts are here to give you the essential steps.

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