Operating Leverage
Definition
Operating leverage measures the proportion of fixed costs in a company's cost structure, indicating how a change in revenue affects operating income.
Explanation
A company with high operating leverage has a higher proportion of fixed costs relative to variable costs. This means that revenue growth leads to disproportionate profit increases, but revenue declines also cause steeper profit drops. Software companies typically have high operating leverage, while service businesses have lower operating leverage.
Operating leverage is calculated by dividing contribution margin by operating income. Understanding operating leverage helps businesses assess risk and make strategic decisions about cost structure and pricing.
Example
A SaaS company with $1 million in revenue, $200,000 in variable costs, and $600,000 in fixed costs has an operating leverage of 1.33. A 10% revenue increase to $1.1 million would boost operating income from $200,000 to $280,000, a 40% increase.