Operating Leverage Ratio

Definition

The term operating leverage ratio refers to a metric used to understand the extent to which fix costs can generate profits. The operating leverage ratio achieves this objective by comparing fixed costs to operating income.

Calculation

Operating Leverage Ratio = (Sales - Variable Expenses) / Operating Income

Where:

  • Sales include the total revenue in the current period.
  • Variable expenses are limited to those that vary in the short run, including sales commissions and direct materials.
  • Operating income is equal to earnings before interest and taxes.

Explanation

Operating performance measures allow the investor-analyst to understand how well a company is performing with respect to sales, margins, and profits. One of the ways to measure the effectiveness of a company's core business is by calculating their operating leverage ratio.

This metric first determines the company's fixed costs by taking sales revenues and subtracting out all short run variable cost including sales commissions and direct materials; this value is then divided by the company's operating income. This metric can be useful when a company would like to understand the extent to which adding fixed assets, such as automation equipment that can displace manual labor, will influence the company's fixed cost structure.

Example

Company ABC manufactures widgets and would like to understand how outsourcing direct labor (a variable expense) will affect the company's operating leverage ratio and operating income. The outsourcing cost is lower than internal labor on a per unit basis and appears to be an opportunity for labor arbitrage; however, the contract has a fixed cost component which does not vary with output, in addition to a variable component.

Company ABC's Chief Financial Officer would like to understand the impact the outsourcing contract will have on its operating leverage ratio. She asked her analysts to provide her with several metrics, including the company's operating leverage ratio. Using the company's latest forecast, the analyst put the following table together.

  No Outsourcing Outsourcing
Sales Revenues $12,500,000 $12,500,000
Fixed Outsourcing Cost $0 $2,000,000
Direct Labor $4,800,000 $2,500,000
Direct Materials $2,700,000 $2,700,000
Other Fixed Costs $4,500,000 $4,500,000
Operating Income (EBIT) $500,000 $800,000
Operating Leverage Ratio 10:1 9:1

Based on the above analysis, Company ABC will increase profits considerably while lowering their operating leverage ratio. Using this information Company ABC's CEO decides to move forward with the outsourcing contract.

Related Terms

net income percentagecore operating earningscore growth ratecash flow from operations ratio