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Operating leverage is the measure of how much fixed costs have an impact on a company's profitability. A company's operating income's sensitivity to fluctuations in sales revenue is gauged by this metric.
Operating leverage is based on how much of a company's total costs are fixed expenditures, such as rent, salary, and depreciation, as opposed to variable costs, such as supplies and labor. While variable costs rise or fall in response to changes in output or sales, fixed costs do not alter as a result of changes in either.
High operating leverage companies have a greater percentage of fixed costs compared to variable costs. This implies that a company's profitability can be significantly impacted by even slight changes in sales volume. Because the fixed expenses stay the same while the variable costs rise in line with sales, a company with high operating leverage can see a higher gain in operating income when sales go up. But if sales fall, a business with significant operational leverage may see a bigger drop in operating income because its fixed expenses stay the same while its variable costs fall in line with falling sales.
Companies with limited operating leverage, on the other hand, have a lower percentage of fixed costs compared to variable costs. Hence, variations in sales volume have a less significant effect on a company's profitability. Because both fixed and variable costs rise proportionately with sales, a business with little operational leverage can see a smaller gain in operating income when sales rise. Yet, because both fixed and variable costs decline proportionally with sales, a business with little operating leverage may see a smaller decline in operating income if sales decline.
