Operating leverage

economic-dictionary

Operating leverage consists of using fixed costs to obtain a higher profitability per unit sold.

Given that as the quantity of goods produced increases, the variable costs will increase at a lower rate and thus also the total costs (variable costs plus fixed costs) will increase at a slower rate, as we increase the production of goods, resulting in a higher profit for each product sold.

Operating leverage is known as the relationship between fixed costs and variable costs used by a company in the production of goods.

Fixed and variable costs

What is operating leverage for?

Thanks to operating leverage, a business manages to reduce total production costs once it has produced more than a certain quantity. That is, as the sales volume in the company increases, each new sale contributes less to fixed costs and more to profitability.

Therefore, operating leverage allows companies to enjoy a higher gross margin (sales price minus variable costs) on each sale. We can know that a company has a high degree of operating leverage if the gross margin on its sales is very high.

The more fixed costs used, the greater the operating leverage. A high degree of operating leverage has a higher risk for the company, since it entails large outlays at the beginning of an activity. If in the end the sale of goods is lower than expected and you must produce fewer products than you had predicted would be necessary to exceed the profitability threshold, the total costs and losses derived from that activity will be greater than if you had had a lower degree of operating leverage.

Operating leverage example

We are going to see graphically what would happen to the profitability of two equal companies, but with two different degrees of operating leverage, depending on the units or products they sell.

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