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Leverage is a powerful tool used in various financial and investment strategies to maximize potential gains or losses. It involves borrowing capital to increase the potential return on an investment. From the world of finance to the realm of business, leverage can be employed to multiply resources and amplify outcomes. However, the concept of leverage is not without risks, as it also magnifies losses when investments do not perform as anticipated. Understanding how leverage works is crucial for investors, businesses, and anyone interested in optimizing their financial endeavors. In this article, we will delve into the mechanics of leverage, its advantages, disadvantages, and explore real-life examples to provide a comprehensive understanding of this fundamental concept in finance.
This article was co-written by Darron Kendrick, CPA, MA. Darron Kendrick is a visiting professor of accounting and law at the University of North Georgia. He received his master’s degree in tax law from Thomas Jefferson School of Law in 2012 and his CPA degree from the Alabama Commission on Public Accountants in 1984.
This article has been viewed 26,301 times.
Operating leverage is a measure of how much profit a company makes from its fixed costs. The more profit a company generates from its fixed costs, the higher its operating leverage. Operating leverage can be calculated using a variety of formulas, but the most common of which is the ratio of variation in contribution margin to the rate of change in operating profit.
Steps
Calculate operating leverage
![Image titled Calculate Operating Leverage Step 1](https://www.wikihow.com/images_en/thumb/f/fd/Calculate-Operating-Leverage-Step-1-Version-2.jpg/v4-728px-Calculate-Operating-Leverage-Step-1-Version-2.jpg)
- For example, suppose Company ABC has total sales of $100,000 in December 2015. Variable costs include: cost of goods – $30,000; Commission – 20,000 USD; Delivery cost – 10,000 USD.
- Contribution balance is 100,000 wonUSEASY−30,000 wonUSEASY−20,000 wonUSEASY−10,000 wonUSEASY=40,000 wonUSEASY{displaystyle 100,000USD-30,000USD-20,000USD-10,000USD=40,000USD} .
![Image titled Calculate Operating Leverage Step 2](https://www.wikihow.com/images_en/thumb/c/c6/Calculate-Operating-Leverage-Step-2-Version-2.jpg/v4-728px-Calculate-Operating-Leverage-Step-2-Version-2.jpg)
- Assume that Company ABC’s fixed costs have: advertising – $2,000; Insurance – $5,000; Rent – 3,000 USD; services – $ 2,000; Salary – $18,000.
- Total fixed costs are $30,000.
- Operating profit is the total revenue minus variable and fixed costs.
- For Company ABC, the total revenue is $100,000. Variable costs are $60,000 and fixed costs are $30,000.
- Thus, profit from business of ABC = 100,000 wonUSEASY−60,000 wonUSEASY−30,000 wonUSEASY=10,000 wonUSEASY{displaystyle 100,000USD-60,000USD-30,000USD=10,000USD} .
![Image titled Calculate Operating Leverage Step 3](https://www.wikihow.com/images_en/thumb/6/61/Calculate-Operating-Leverage-Step-3-Version-2.jpg/v4-728px-Calculate-Operating-Leverage-Step-3-Version-2.jpg)
- Operating leverage = contribution margin / operating profit.
- 40,000 wonUSEASY/10,000 wonUSEASY=4{displaystyle $40,000/10,000USD=4}
- Company ABC’s operating leverage is 4.
Analysis of operating leverage
![Image titled Calculate Operating Leverage Step 4](https://www.wikihow.com/images_en/thumb/7/79/Calculate-Operating-Leverage-Step-4-Version-2.jpg/v4-728px-Calculate-Operating-Leverage-Step-4-Version-2.jpg)
- The higher the fixed cost as a percentage of total costs, the greater the operating leverage will be.
- Higher operating leverage means your net income grows at a faster rate.
![Image titled Calculate Operating Leverage Step 5](https://www.wikihow.com/images_en/thumb/b/b2/Calculate-Operating-Leverage-Step-5-Version-2.jpg/v4-728px-Calculate-Operating-Leverage-Step-5-Version-2.jpg)
- Contribution balance is 100,000 wonUSEASY−30,000 wonUSEASY=70,000 wonUSEASY{displaystyle 100,000USD-30,000USD=70,000USD} .
- Net profit from trading is 100,000 wonUSEASY−30,000 wonUSEASY−60,000 wonUSEASY=10,000 wonUSEASY{displaystyle 100,000USD-30,000USD-60,000USD=10,000USD} .
- Operating leverage = contribution margin / operating profit.
- 70,000 wonUSEASY/10,000 wonUSEASY=7{displaystyle 70,000USD/10,000USD=7} .
- Thus, the net profit from business of company XYZ increased 7 times compared to sales.
![Image titled Calculate Operating Leverage Step 6](https://www.wikihow.com/images_en/thumb/2/21/Calculate-Operating-Leverage-Step-6-Version-2.jpg/v4-728px-Calculate-Operating-Leverage-Step-6-Version-2.jpg)
- Assume that the two companies in the above examples both experience a 10% increase in sales.
- Company ABC, with operating leverage of 4, will increase its net profit margin by 40% with a 10% increase in sales. (ten%∗4=40%){displaystyle (10%*4=40%)} .
- Company XYZ with operating leverage of 7, will increase its net profit margin by 70% with sales increasing by 10% (ten%∗7=70%){displaystyle (10%*7=70%)} .
- As a result, you can use operating leverage to quickly calculate the impact of changes in sales on your net operating profit, without the need to prepare detailed financial statements.
Risk assessment by operating leverage
![Image titled Calculate Operating Leverage Step 7](https://www.wikihow.com/images_en/thumb/d/de/Calculate-Operating-Leverage-Step-7-Version-2.jpg/v4-728px-Calculate-Operating-Leverage-Step-7-Version-2.jpg)
- For example, suppose company ABC in the example above has revenues of $75,000, variable costs of $45,000, and fixed costs of $30,000.
- Contribution balance will be 75,000 wonUSEASY−45,000 wonUSEASY=30,000 wonUSEASY{displaystyleUSD 75,000-45,000USD=30,000USD} .
- Net profit from trading will be 75,000 wonUSEASY−45000USEASY−30,000 wonUSEASY=0USEASY{displaystyle 75,000USD-45000USD-30,000USD=0USD} .
- Operating leverage will be 30,000 wonUSEASY/0USEASY=infinite{displaystyle $30,000/0USD={text{ infinite }}} .
![Image titled Calculate Operating Leverage Step 8](https://www.wikihow.com/images_en/thumb/9/92/Calculate-Operating-Leverage-Step-8.jpg/v4-728px-Calculate-Operating-Leverage-Step-8.jpg)
- This is why investors should be cautious when investing in companies with high operating leverage.
![Image titled Calculate Operating Leverage Step 9](https://www.wikihow.com/images_en/thumb/8/86/Calculate-Operating-Leverage-Step-9.jpg/v4-728px-Calculate-Operating-Leverage-Step-9.jpg)
This article was co-written by Darron Kendrick, CPA, MA. Darron Kendrick is a visiting professor of accounting and law at the University of North Georgia. He received his master’s degree in tax law from Thomas Jefferson School of Law in 2012 and his CPA degree from the Alabama Commission on Public Accountants in 1984.
This article has been viewed 26,301 times.
Operating leverage is a measure of how much profit a company makes from its fixed costs. The more profit a company generates from its fixed costs, the higher its operating leverage. Operating leverage can be calculated using a variety of formulas, but the most common of which is the ratio of variation in contribution margin to the rate of change in operating profit.
In conclusion, leverage is a powerful financial tool that allows individuals and businesses to multiply their potential returns on investment. By using borrowed funds to invest, leverage enables individuals to control larger positions in assets than they would be able to with their own capital alone. While leverage can greatly amplify gains and increase profits, it also introduces a significant level of risk. It is essential for investors to understand and carefully manage the risks associated with leverage, including the potential for amplified losses and increased exposure to market fluctuations. Proper risk management, such as setting and adhering to leverage limits, conducting thorough research, and maintaining a diversified portfolio, is crucial when utilizing leverage. Despite the risks, leverage has the potential to enhance investment opportunities and generate higher returns for those who understand how it works and use it responsibly.
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