Operating leverage describes in mathematical terms the sensitivity of net operating income to changes in sales. As an example, assume that the level of sales for an accounting period is $200,000, and that the net operating income on that level of sales is $20,000 (10% of sales). Net operating income is determined (a) by subtracting variable expenses from sales to obtain the contribution margin, and then (b) by subtracting fixed expenses from the contribution margin. Assume further in this example that variable expenses are 70% of sales and that fixed expenses are $40,000. The contribution margin then is $60,000 (30%) and net operating income is $20,000. The degree of operating leverage then is 3 ($60,000 / $20,000).
Using this information, a 15% increase in sales would be accompanied by a 15% in variable expenses and a 15% increase in the contribution margin. Fixed expenses would not change. Thus, net operating income increase by $9,000, which is a 45% increase in net operating income or 3 times (the degree of operating leverage) the percentage increase in the contribution margin.
The degree of operating leverage tends to vary across industries by the le level of fixed expenses. Thus, companies engaged in manufacturing typically will have higher fixed expenses that will companies engaged in service industries because of the fixed asset base (factories and equipment) that is required for manufacturing. Similarly, companies that are engaged in e-commerce will have lower fixed expenses than will companies engaged in traditional merchandising become e-commerce companies do not have the fixed asset requirement for brick-and-mortar stores.
Managers can use the degree of operating leverage in the assessment of the cost structure of their companies. If it is feasible to replace some fixed expenses with variable or semi-variable expenses, the degree of operating leverage can be improved, which in turn wil...