operating leverage

Operating leverage

Fixed operating costs, which are characterized as leverage because they accentuate variations in profits.

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operating leverage

The extent to which fixed operating costs magnify changes in sales or revenues into even greater proportionate changes in operating income. For example, a company that substitutes robots or other machinery for laborers also substitutes fixed costs for variable costs and increases its operating leverage. High operating leverage tends to produce volatile earnings. Compare financial leverage.

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operating leverage

The phenomenon of inflation leading to increased income and expenses each year,at the same time that financing (leverage) expenses remain the same if the borrower has fixed-rate financing.The result is that cash flows increase over time.

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Operating Leverage

What Does Operating Leverage Mean?

A measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. (1) A business that has limited sales, with each sale providing a very high gross margin, is said to be highly leveraged. A business that makes many sales, with each sale contributing a very low margin, is said to be less leveraged. As the volume of sales in a business increases, each new sale contributes less to fixed costs and more to profitability. (2) A business that has a higher proportion of fixed costs and a lower proportion of variable costs is said to use more operating leverage. Conversely, businesses with lower fixed costs and higher variable costs are said to employ less operating leverage.

Investopedia explains Operating Leverage

The higher the degree of operating leverage, the greater the potential danger for inaccurately forecasting risk. That is, if a relatively small error is made in forecasting sales, it can be magnified into large errors in projections of cash flow. The opposite is true for businesses that are less leveraged. A business that sells millions of products a year, with each contributing slightly to paying for fixed costs, is not as dependent on each individual sale. For example, convenience stores are significantly less leveraged than are high-end car dealerships.

Related Terms:
• Cash Flow
• Debt
• Gross Margin
• Leverage
• Volume