Operating leverage explained

Operating leverage refers to relative amount of costs that are fixed and variable in the cost structure of a business. Some companies will have relatively high fixed costs compared to variable costs and are said to have a high operating leverage. For example, pharmaceutical companies incur up to $1billon to develop new drugs over a 10 to15 period[1], whereas the manufacture cost pennies – just think of the price of a pack of paracetemol in your local pharmacy. Low operating leverage means variable costs are a relatively high proportion of total costs. Retailers like Tesco or Sainsbury have relatively low fixed costs and relatively high variable costs – the variable cost of each item sold (e.g. the purchase price) is likely to be much higher than the associated fixed cost for that item. The degree of operating leverage of a company can be used to assess its risk profile. Companies with high operating leverage are more vulnerable to decreasing sales e.g. sharp economic and business cycle swings. Companies with a high level of costs tied up in machinery, plants and equipment cannot easily cut costs to adjust to a change in demand. So, if there is a downturn in the economy revenues and profits can plummet. On the other hand, companies with lower operating leverage can adapt their cost structure more rapidly as it has more variable costs.

[1] http://www.washingtontimes.com/news/2009/mar/13/blocking-drug-development/ accessed  Dec 4th, 2009


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About martinjquinn

I am an accounting academic, accountant and author based near Dublin, Ireland.

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