Operating Leverage – At a Glance

There are probably as many models and formulas used in the world of business as there are business types themselves.  Formulas can help figure up everything from profit margin to human resource effectiveness, but one of the most important formulas to familiarize yourself with is that of operating leverage.  This term refers to operating income and operating costs of a few different varieties, and it can influence the valuation of a company, its risk level, and much more.  It could even determine whether or not investors or lenders are willing to provide funds to the company.  In other words, it’s a vital cog in the business machine and one that is well worth learning more about.

In most cases, operating leverage is tied very closely to financial leverage – so much so that the two are practically analogous.  A number of figures can help you judge the operating leverage of company, but the most commonly used formula is simply the fixed costs plus the variable costs.  Adding these two figures together will give you the total costs.  For example, employee salaries, lease amount, and other similar costs will be fixed while things like restocking inventory or even marketing can be considered to be variable costs.

Another computation to address is debt plus equity to provide a look at total assets.  This will correlate with total costs and provide a clearer picture of operating leverage.  Various other factors also contribute to these figures, including things like the contribution margin, percentage of change in sales for a given time period, and much more.  In simple terms, the higher a company’s operating leverage, the more that sales volume will impact its bottom line.  A slow month of sales could nearly cripple a company with a very high OL, which makes it important for all business owners to keep an eye on their leverage at any given time.

Obviously, business owners aren’t the only ones who need to consider operating leverage.  Investors and lenders will take a close look at it as well before providing any kind of serious money to the business in question.  That’s because while investing or lending certainly isn’t without its risks, a variety of different factors can help reduce that risk to a more acceptable level.  Operating leverage is a perfect example of this and one of the main reasons that it’s so important.  While certain companies will be unable to control their leverage, just understanding it is important as well.

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