Operating Leverage Formula

Operating Leverage Formula (Table of Contents)

• Formula
• Examples
• Calculator

What is the Operating Leverage Formula?

The term “Operating Leverage” refers to the ratio that shows how much a company benefits in terms of operating profit from the mix of fixed cost and variable cost in its overall cost structure. In other words, the ratio measures how much the operating profit of a company increases of a company increases with the increase in its revenue, primarily due to better absorption of the fixed cost component. The formula for operating leverage a.k.a. degree of operating leverage, can be expressed by dividing % change in operating profit (EBIT) by % change in revenue. Mathematically, it is represented as,

Formula

Let us take the simple example of a tech company named Mango Inc. During 2018; the company reported revenue of $75.0 million vis-à-vis revenue of $65.0 in 2017. The company’s EBIT also increased to $30.0 million in 2018 vis-à-vis $27.0 million in 2017. Calculate Mango Inc.’s degree of operating leverage on the basis of the given information.

Solution:

% Change in the Company’s EBIT is calculated using the formula given below

% Change in EBIT = (EBIT ₂₀₁₈ – EBIT ₂₀₁₇) / EBIT ₂₀₁₇ * 100%

• % Change in EBIT = ($30.0 million – $27.0 million) / $27.0 million * 100%
• % Change in EBIT = 11.11%

% Change in the Company’s Revenue is calculated using the formula given below

% Change in Revenue = (Revenue ₂₀₁₈ – Revenue ₂₀₁₇) / Revenue ₂₀₁₇ * 100%

• % Change in Revenue = ($75.0 million – $65.0 million) / $65.0 million * 100%
• % Change in Revenue = 15.38%

The degree of Operating Leverage is calculated using the formula given below.

Degree of Operating Leverage = % Change in EBIT / % Change in Revenue

• Degree of Operating Leverage = 11.11% / 15.38%
• Degree of Operating Leverage = 0.72x

Therefore, based on the given information, it can be seen that Mango Inc.’s degree of operating leverage is 0.72x.

Operating Leverage Formula – Example #2

Let us now take the example of Samsung Electronics Co. Ltd. in order to illustrate the concept of operating leverage for a real-life company. According to its annual report for the year 2018, Samsung achieved revenue of $221.57 billion in 2018 vis-à-vis revenue of $217.75 billion in 2017, while it achieved operating income of $63.39 billion in 2018 vis-à-vis that of $59.24 billion in 2017. Based on the given information, calculate the operating leverage of Samsung Electronics Co. Ltd.

Solution:

% Change in the Company’s EBIT is calculated using the formula given below

% Change in EBIT = (EBIT ₂₀₁₈ – EBIT ₂₀₁₇) / EBIT ₂₀₁₇ * 100%

• % Change in EBIT = ($63.39 billion – $59.24 billion) / $59.24 billion * 100%
• % Change in EBIT = 7.04%

% Change in the Company’s Revenue is calculated using the formula given below

% Change in Revenue = (Revenue ₂₀₁₈ – Revenue ₂₀₁₇) / Revenue ₂₀₁₇ * 100%

• % Change in Revenue = ($221.57 billion – $217.75 billion) / $217.75 billion * 100%
• % Change in Revenue = 1.75%

The degree of Operating Leverage is calculated using the formula given below.

Degree of Operating Leverage = % Change in EBIT / % Change in Revenue

• Degree of Operating Leverage = 7.00% / 1.75%
• Degree of Operating Leverage = 4.01x

Therefore, the company’s degree of operating leverage can be calculated as 4.01x based on the given information.

Source Link: Samsung. Balance Sheet

Explanation

The formula for Operating Leverage can be calculated by using the following steps:

Step 1: Firstly, figure out the company’s operating profit for the current (EBIT_x) and the preceding period (EBIT_x-1). In most companies, operating income is available as a separate line item in any company’s income statement.

Step 2: Next, calculate the % change in EBIT by dividing the difference between EBIT_x and EBIT_x-1 by EBIT_x-1, as shown below.

% Change in EBIT = (EBIT_x – EBIT_x-1) / EBIT_x-1 * 100%

Step 3: Next, figure out the revenue of the company during the current (Revenue_x) and the previous period (Revenue_x-1). It is usually available as the first line item in the income statement of any company.

Step 4: Next, calculate the % change in revenue, dividing the difference between Revenue_x and Revenue_x-1 by Revenue_x-1 as shown below.

% Change in Revenue = (Revenue_x – Revenue_x-1) / Revenue_x-1 * 100%

Step 5: Finally, the formula for operating leverage can be derived by dividing % change in EBIT (step 2) by % change in revenue (step 4) as below.

Degree of Operating Leverage = % Change in EBIT / % Change in Revenue

Relevance and Use of Operating Leverage

The concept of operating leverage is very important as it helps in assessing much a company can benefit from the increase in revenue. Based on the expected benefit, a company can schedule its production or sales plan for a period. A company with a higher proportion of fixed cost in its overall cost structure is said to have higher operating leverage. Typically, a company with a higher value of operating leverage is expected to have an increased in profitability with an increase in revenue, as higher revenue allows better absorption of fixed costs. On the other hand, a company with a lower value of operating leverage experiences nominal to no change in its profitability with an increase in revenue.

However, it is important to note that a company with high operating leverage is exposed to the risk of financial losses in case of a significant decline in revenue as a large portion of the cost structure is fixed in nature. As such, high operating leverage can be a double-edged sword.

Operating Leverage Formula Calculator

You can use the following Operating Leverage Formula Calculator

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