Operating Leverage: Meaning, Formulas, and Example Calculations

Operating Leverage Definition

Operating Leverage tells you how much of a company’s expenses are fixed (i.e., they do not change with production volume) vs. variable (i.e., they do change with production volume); higher operating leverage means that as sales grow, more of these sales “trickle down” into a company’s Operating Income.

For example, software companies tend to have high operating leverage because most of their spending is upfront in product development.

Selling each additional copy of a software product costs little since the distribution is almost free, and no “raw materials” are required (just support costs, infrastructure/bandwidth, etc.).

On the other hand, consulting or services companies have low operating leverage because most of their spending is variable: as sales increase, their spending increases in lockstep, and as sales decrease, their spending also decreases.

This is because whenever they charge a client for a billable hour, they must pay one of their employees to deliver the service.

Here’s a quick comparison to illustrate the concept for two $1 billion revenue companies, one in software and one in services:

Microsoft could sell 50,000 copies of Windows or 10 million copies, and their expenses would be almost the same because it costs very little to “deliver” each copy.

But if a consulting firm bills clients for 1,000 hours vs. 100 hours, their expenses would be ~10x higher because they would need to pay their employees for 10x the hours.

Files & Resources:

Operating Leverage – Slides (PDF)

Operating Leverage – Software Company vs. Services Company (XL)

Operating Leverage Formula: How to Calculate Operating Leverage

There are several different formulas for calculating operating leverage:

Operating Leverage Formula 1: Fixed Costs / (Fixed Costs + Variable Costs)

This formula relates to the key definitions above and makes intuitive sense.

In the example above, it produces 0.67x for the software company and 0.02x for the services company, indicating much higher operating leverage for the SW company:

However, most companies do not explicitly spell out their fixed vs. variable costs, so in practice, this formula may not be realistic.

Operating Leverage Formula 2: % Change in Operating Income / % Change in Sales

This formula is the easiest to use when you’re analyzing public companies with limited disclosures but multiple years of data.

For example, if Company A’s EBIT (Operating Income) increases from $100 to $150 as its Sales increase from $1000 to $2000, its Operating Leverage is 50% / 100% = 50%.

The disadvantage of this formula is that it’s indirect: it doesn’t directly account for fixed vs. variable costs, and other items or business policies could affect both Operating Income and Net Sales.

Operating Leverage Formula 3: Net Income / Fixed Costs

We tend not to use this formula because it requires the Fixed Costs for the company, and most large/public companies do not disclose this number (see above).

However, you could use this formula if you assume that the company’s Operating Expenses are its Fixed Costs and that its Cost of Goods Sold or Cost of Services are all Variable Costs.

Operating Leverage Formula 4: Contribution Margin or Gross Margin / Operating Margin

We can use this approach in the software vs. services example shown above.

The Contribution Margin is essentially the Gross Margin, so for the software company, we take the 10 million units sold, multiply by the $80.00 in Gross Profit per unit, and divide by the $1 billion in revenue:

This approach produces 2.0x for the software company vs. 1.0x for the services company, which understates the operating leverage differences.

Is High Operating Leverage “Good”?

Any type of leverage means higher risk and higher potential rewards.

With operating leverage, the higher potential rewards come if the company increases its sales – which will translate into higher Operating Income and Net Income.

When sales increase, fixed assets such as property, plant, and equipment (PP&E) can be more productive without additional expenses, further boosting profit margins.

However, high operating leverage also creates greater risk in some contexts.

For example, a company with high fixed costs might find it difficult to manage a downturn, recession, or other business shock because it cannot reduce its expenses in response to falling sales – as a company with high variable costs could.

Regardless of sales levels, the company must spend a certain amount to continue operating.

We saw this with airlines during COVID-19 and the travel restrictions that took effect in 2020; many airlines had to be bailed out due to greatly reduced ticket sales and their low Cash balances and poor liquidity ratios.

However, the risk from high operating leverage also depends on the company’s overall Operating Margins.

For example, if a company has very high margins, such as 40%+, it can weather a downturn better than a company with much lower margins (< 10%).

These companies with high operating leverage and low margins tend to have much more volatile earnings per share figures and share prices, and they might find it difficult to raise financing on favorable terms.

How to Interpret Operating Leverage in Real Life

Given the points above, the operating leverage metric is MOST meaningful when you calculate it for companies in the same industry with roughly the same operating margins (i.e., the comparable companies).

You shouldn’t use it to compare a software company to a manufacturing company because their business models are completely different.

Also, the operating leverage metric is useless in some industries because it fluctuates too much or cannot be reasonably calculated based on public information.

Here’s an example comparison of operating leverage for several U.S.-based discount retailers:

These numbers are nonsensical; all we can say is, “It seems like the overall industry is becoming less efficient because operating leverage is falling for most of these firms.”

Most investors, such as private equity firms and venture capitalists, prefer companies with high operating leverage because it makes growth faster and easier.

But it also depends on the firm’s strategy, focus industry, and the specific companies.

The airline industry, with “high operating leverage,” has performed terribly for most investors, while software / SaaS companies, which also have “high operating leverage,” have made many people wealthy.

So, while operating leverage is a good starting point for an analysis, it gives you an incomplete picture unless you also consider overall margins and industry dynamics when comparing companies.