Moneyzine
/Investment Guides /Operating Leverage Ratio

Operating Leverage Ratio

Moneyzine Editor
Author: 
Moneyzine Editor
2 mins
September 20th, 2023
Advertiser Disclosure

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 OutsourcingOutsourcing
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 Ratio10:19:1

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 percentage, core operating earnings, core growth rate, cash flow from operations ratio

Explore Investing Further

  • Trading has never been easier, thanks to the rise of online platforms that enable you to buy and sell various assets at the click of a button. But with so many options available, it can be challenging to decide which platform is right for you.
  • Looking for a way to avoid swap fees while trading forex?
  • By providing instant diversification for your portfolio, investing in ETFs can amplify the potential of any investor, novice or seasoned alike. We scoped the market to curate a list of the best ETF trading platforms available for US investors.
  • Our top beginner's pick for copy trading is eToro. Read on for more details, plus seven good alternatives.
  • Swing trading stocks can be a great way for investors to take advantage of short-term stock market movements and gain significant returns. If you're interested in swing trading, the key to success lies in selecting the right stocks to buy and sell quickly for a profit.
  • The table below lists the best stock picks under $2, listed on public exchanges.
  • The table below lists the best stock picks under $1, listed both on public and OTC exchanges.
  • This section will highlight the best EV-trading penny stocks available in the United States.
  • The demand for sustainable energy has grown rapidly in recent years. This has resulted in increased scrutiny of the automotive market. As a result, the electric vehicle (EV) industry has made significant advancements.
  • Intelligent Bio Solutions Inc. is a life sciences company, founded in 2016 with headquarters in New York and is engaged in performing diagnostic tests, real-time monitoring, and non-invasive surgery for its patients. The firm has developed a CoV-2 Biosensor, which can be used in RNA virus detection.
  • Hour Loop was founded in 2013 with headquarters in Redmond, Washington. It’s an online retailer involved in e-commerce in the United States that hit the public markets on Jan 7th of 2022. The company sells home/garden decor, electronic products, kitchenware, and apparel through walmart.com, amazon.com, and hourloop.com.

Related Content

  • Biden Or Trump: Who Is Better For The Economy And Stocks?
    Yup. This is one of those articles. It's an election year, and here in the U.S., we get to decide which old dude who’s been alive long enough to remember when there were only 48 states in the U.S. will be the leader of the free world.
    March 19th, 2024
  • When it comes to strategic business planning, accounting is front and center, shaping the course of action. At least it should be.
    March 14th, 2024
  • How To Invest in Real Estate Without Becoming a Landlord
    We all know that in order to build wealth and prepare for retirement, investing is the key. However, it can be hard to figure out what to invest in and how to put your money to good use. One of the most talked about ways to build wealth is owning property and being a landlord to bring in passive income. But what if you don’t want to do that? You can still invest in real estate!
    November 15th, 2024
  • Investing In Nature: The Closest You'll Get To Your Money Growing On Trees
    ESG (Environmental, Social, and Governance) has become a polluted word for many traders and investors - but that doesn't mean it's going completely away. Nor does that mean you can't profit from nature or sustainable practices. But there are some opportunities in the regenerative ag, conservation, and green real estate spaces.
    February 29th, 2024
  • How to Invest $100 and Grow it to 6 Figures
    Turning $100 into six figures is a goal no one should realistically have. But it's the question you might ask yourself: Can it be done? Sure. Probable? It's less probable than winning the lottery, but technically still probable - like finding a needle in a haystack the size of Canada. But possible? Absolutely.
    October 29th, 2024

Contributors

Moneyzine Editor
The Moneyzine editorial team consists of writers and content specialists with diverse backgrounds.
Moneyzine 2024. All Rights Reserved.