The meaning of operating leverage is the accounting term that aims to increase the profitability modifying the balance between variable costs and fixed costs. It can be considered as the impact that these have on the general costs of the company, referring to the relationship between sales and its profits before taxes and interest.
Another definition of operating leverage is the use of costes fixed to achieve greater profitability per unit sold. By increasing the quantity of goods produced, variable costs will rise at a slower rate, and also total costs (fixed costs plus variable costs) will also increase but at a lower intensity. As the production of goods grows, a greater profit will arise for each item traded.
Objective of operating leverage
Operating leverage is a type of leverage that allows a company to lower total production costs once it has produced a specific quantity of that product. Therefore, with the increase in the volume of sales of a company, there will come a time when with each new sale there will be a lower fixed cost and profitability will increase.
This implies that operating leverage will make it easier for companies to have a greater gross margin at every sale. When this gross margin (sale price less variable costs) is very high, it can be said that the company has a high degree of operating leverage. The more fixed costs used, the higher the operating leverage.
It should be clarified that a high degree of leverage also presents a greater risk for the business, since it implies a higher outlay and expense at the beginning of the activity. When product sales turn out to be lower than expected and fewer items need to be manufactured than predicted would be needed to exceed the break-even threshold, the total losses and costs of this activity will be higher than if they had had a lower degree of operating leverage.