Operating Leverage (What is it, Risk, Advantages and Disadvantages)

Category: Agenda

What is operating leverage?

Operating leverage is an accounting concept that seeks to increase profitability by changing the balance between variable costs and fixed costs. It can be defined as the impact these have on the overall costs of the company. Refers to the relationship between sales and profits before interest and taxes.

It also defines the ability of companies to use fixed operating costs to maximize the effects of changes in sales on profits, also before interest and taxes.

Changes in fixed costs Operating leverage affects operating leverage, since it constitutes an amplifier of both losses and gains. Thus, the higher the degree of operating leverage, the greater the risk, since a higher marginal contribution is required to cover fixed costs.

In other words, the substitution of variable costs for fixed costs will allow, for example, in a production company, the profit margin between the quantity of unit sold and the costs incurred, this will increase the profit per unit sold, which generates higher profitability, generating in turn greater operating profit.

In general, operating leverages are established in companies that have a production system that is automatic, that is, the technical procedures in production are efficient and the company has invested in expanding its production capacity through implementation through new technologies.

What is the risk of Operating Leverage?

When a company undertakes to apply operating leverage to improve its gross profit, it is exposed to great risk, since while it may well increase profits, an error in planning or execution can also generate significant losses for the company.

This is because in automatic processes a small error can have a great impact on the final products, since this error would affect each of the production stages.

On the other hand, in a booming economy having a high level of operating leverage helps to maximize profits, but the market can change due to various factors and in a country that is in crisis it can cause sales levels to drop and the high level. of fixed costs that the company possesses affect its liquidity and convert the result from profit to loss.

What are fixed and variable costs?

The costs in general are those expenses that the company must incur directly for the provision of a service or to produce a good, as they are necessary to generate a profit, these are deducted from the sales it has made and thus profitability is measured.

Based on the above, fixed costs are those that are kept constant from month to month and that do not vary regardless of the level of production, on the contrary, variable costs are closely related to the amount of services or goods produced, to The greater the number of the former, the greater the implicit cost to carry them out.

The classification of fixed or variable will depend on the company’s line of business, although the expenses of basic services such as electricity or water will be a fixed expense in a company that provides an accounting service, compared to a production company that will spend higher light level depending on the level of production you have month to month.

Advantages and disadvantages of Operating Leverage

Operating leverage, like the other management decisions of a company, will be functional to the extent that internal and external conditions are aligned, otherwise the risk of the company obtaining a bad economic situation is quite high.

For this reason, we point out one by one the main advantages and disadvantages that operating leverage offers.

Advantage

  • It allows to improve the utility of the company in a highly efficient way, allowing the largest number of services and production to not have an impact that raises costs in the same proportion.
  • It helps the company to more accurately project and analyze its cash flows by taking into account the fixed cost it will pay during the year.
  • It generates greater control over the costs that are incurred for production.
  • It allows updating the technology and technical processes of the company.

Disadvantages

  • With so many large volume fixed costs, a liquidity problem may arise in the event of a termination in sales.
  • Similarly, the drop in production levels of projected sales has a direct impact on the results expected by the company.
  • It increases that the risk of a process error can damage the entire production line.

Difference between Operating Leverage and Financial Leverage

Operating leverage is based on the company’s internal management and its production capacity, on the other hand, financial leverage arises from the company’s need to seek financing from third parties in order to improve its economic position.

These indebtedness arising from third-party financing can have positive or negative effects depending on the efficiency with which the capital received from third parties is used and the impact on the improvement of the company’s profit margins.

It is important to mention that another difference is that the financial lease generates a financial cost for the interests that must be paid due to the capital obtained, so that although the gross profit is not compromised, the net profit will reflect the effect of the financial interests. paid.

The operating leverage searches that through fixed incomes in their costs their margins improve profit, on the other hand, financial leverage is a strategy that using third party capital to improve some of my processes, even if this means me a liquidity risk and a financial interest expense.