Operating leverage
Factual definition
Operating leverage is the effect by which fixed operating costs can amplify percentage changes in operating profit relative to changes in sales. The effect depends on contribution margin, capacity and cost behavior; a positive-profit starting point is needed for the usual percentage comparison.
Operating leverage in round numbers
Hypothetical annual US$ millions: revenue of 100.00 less variable cost of goods sold of 69.50 gives gross profit of 30.50. With fixed selling, general and administrative expense (SG&A) of 24.69 and no other operating costs, operating income is 5.81.
Assume unchanged prices, variable COGS at 69.5% of revenue, sufficient capacity and fixed SG&A over the illustrated range. At revenue of 110.00, COGS is 76.45 and operating income is 8.86: a 10% sales increase produces approximately 52.50% operating-profit growth.
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| Measure | Base | Higher sales |
|---|---|---|
| Revenue | 100.00 | 110.00 |
| Variable COGS | 69.50 | 76.45 |
| Gross profit | 30.50 | 33.55 |
| Fixed SG&A | 24.69 | 24.69 |
| Operating income | 5.81 | 8.86 |
A ten-percent sales decline removes more than half the profit
Use the same annual cost assumptions and reduce revenue from US$100m to US$90m. Variable COGS becomes US$62.55m, gross profit US$27.45m and operating income US$2.76m after US$24.69m fixed SG&A.
Operating income falls by US$3.05m from US$5.81m, or about 52.50%, while revenue falls 10%. This is the downside of the same assumed cost structure shown above.
Break-even revenue under that structure is US$24.69m ÷ 30.5%, or about US$80.95m. Near zero profit, percentage changes become a poor summary, so inspect profit dollars and the actual cost commitments.
These results hold only while price, variable-cost percentage, fixed costs and capacity behave as assumed. Lost discounts, severance or a step-change in staffing would require a different calculation.
Where Operating leverage fits
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