Introduction to this document

Operating leverage calculator

In times when sales are volatile, profitability depends on the level of your company’s operating leverage. You can help your business by working out what this is and identifying steps to improve it.

Fixed costs

Operating leverage measures the impact of a change in sales on operating profits. If an increase or decrease in sales causes a smaller than proportionate change in operating profits, then operating leverage is said to be low. Alternatively, if any given change in sales results in a larger than proportionate change in operating profits, then operating leverage is high.

A company with a high level of operating leverage is riskier because when sales fall, the impact on profits (and cash flow) is more severe and excessive losses can be incurred. The underlying factor influencing operating leverage is, of course, the balance between a company’s fixed and variable costs. A company with a higher fixed cost base will have a higher level of operating leverage. Analyse the main fixed costs in the company and categorise them as potentially variable or definitely fixed using Sheet 2 of our Operating Leverage Calculator.

Use Sheet 1 to then work out the figure for your company. If your business has high operating leverage and sales are uncertain, you need to ensure your forecasts include appropriate downside scenarios to anticipate, well in advance, any potential cash flow problems.

Variable costs

A high operating leverage means your company’s profits could be severely affected by volatile sales. Reducing your fixed costs will reduce your operating leverage. Potentially variable costs are those that can be converted from fixed to variable and so reduce your company’s operating leverage. Examples include:

  • Employee costs. Generally fixed in the short term; however, using temporary labour can shift the balance towards variable cost.
  • Motor vehicles. Keeping a fleet of delivery vehicles is another fixed cost that you can convert to a variable cost by outsourcing.

Use our operating leverage calculator to look at the impact on operating leverage and budgeted or forecast profits of increasing the level of variable costs, and present your findings to the board.