Operating Leverage

A company with high fixed costs and low variable costs has high operating leverage. Once its fixed costs are covered, most of each extra sale goes straight to profit, so profits rise quickly when sales grow. But when sales fall, profits drop quickly too, because fixed costs remain.

For example, a company has revenue of 1,000, variable costs of 400 and fixed costs of 400, giving operating income of 200. If sales rise by 10%, revenue becomes 1,100 and variable costs 440, while fixed costs stay at 400. Operating income rises to 260, an increase of 30%. A 10% rise in sales produced a 30% rise in profit.

This multiplier is measured by the degree of operating leverage, which here is 3. It can be calculated as contribution margin divided by operating income: 600 divided by 200.

Businesses such as airlines, software companies and manufacturers with expensive equipment tend to have high operating leverage. Service businesses with mostly variable costs tend to have low operating leverage.

High operating leverage amplifies risk. In a downturn, such companies can move quickly from profit to loss, which is why analysts consider cost structure when assessing a company's stability.