The purpose of operating leverage is the same as all ratios.Measuring operating leverage shows how much profit a company makes from its fixed costs.The operating leverage is the amount of profit a company can earn on a constant level of fixed costs.A number of different formulas are used to calculate operating leverage.The ratio of contribution margin to operating income is one of the most common formulas used.
Step 1: The contribution margin is calculated.
The contribution margin is the difference between total sales and variable expenses.Variable expenses increase with each sale.Cost of goods sold, sales commission and delivery expenses are examples of variable expenses.The contribution margin is calculated by subtracting expenses from total sales.Company ABC had $100,000 in total sales in December of 2015.The variable expenses were the cost of goods sold, sales commission, and delivery expenses.The contribution margin is between $100,000 and20,000.
Step 2: How much do you think operating income should be?
All operating expenses except interest and taxes are considered operating income.If you already deducted variable expenses from total sales, then subtract fixed expenses to calculate operating income.Advertising, insurance, rent, utilities and payroll wages are fixed expenses.Company ABC's fixed expenses would be advertising, insurance, rent, utilities, and wages.The total expenses are $30,000.Total sales are less variable and fixed expenses are more variable.The total sales were $100,000 for Company ABC.The variable and fixed costs are $60,000 and $30,000, respectively.The operating income is $100,000 to $60,000.
Step 3: Use operating leverage to calculate it.
The contribution margin is divided by the operating income.ABC has a contribution margin of $40,000.The operating income is $10,000.ABC has an operating leverage of 4.
Step 4: Evaluate profitability by using operating leverage.
How fast your operating income grows is determined by operating leverage.Company ABC has an operating leverage of 4.The operating income grows four times faster than sales.The number changes depending on the ratio of fixed to variable costs.Your operating leverage is going to be higher if your fixed expenses are more than a percentage of total expenses.Net income grows at a faster rate with higher operating leverage.
Step 5: The impact of higher fixed expenses and lower variable expenses should be analyzed.
Company ABC has the same sales and operating margin.Its variable and fixed expenses are $30,000 and $60,000, respectively.The contribution margin is $100,000.The operating income is between $100,000 and $60,000.Contribution margin is the operating income.$70,000/$10,000 is the displaystyle.Company XYZ has an operating income that grows 7 times as fast as its sales.
Step 6: The impact on profit margin can be predicted.
If you want to know how much your profit margin will increase, use the operating leverage.The operating leverage is calculated by the percent increase in sales.You can expect your profit margin to increase by this percentage.Two companies in the above examples would have an increase in sales.A 10 percent increase in sales should increase the net profit margin by 40 percent.A 10 percent increase in sales should increase the company's net profit margin by 70 percent.If you want to calculate the impact of changes in sales on your operating income, you can use the operating leverage.
Step 7: Evaluate the company's risk profile.
Companies can substantially increase their profits with small increases in sales if they have high operating leverage.They have a lot of money tied up in fixed costs such as machinery, real estate and wages.If the economy goes through a downturn, they don't have a lot of time to cut expenses to preserve their profit margin.When investing in companies with high operating leverage, investors should be cautious.
Step 8: Care should be applied with operating leverage.
The capacity of a company to increase its profit margin can be overstated.A company with an operating leverage of 7 should be able to increase its profit margin seven times faster than its sales.In order to increase sales, the company may need to add labor or expand into a larger space.The measures would increase fixed costs and the company wouldn't see the growth in profit margin predicted by the degree of operating leverage.