What is operating leverage?

Operational leverage is an accounting concept that seeks to increase profitability by modifying the balance between variable and fixed costs. It can be defined as the impact they have on the overall costs of the company. It refers to the relationship that exists between sales and their 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 costsoperating leverage affects operating leverage, since this constitutes an amplifier of both losses and gains. Thus, the greater the degree of operating leverage, the greater the risk, since a larger marginal contribution is required to cover fixed costs.

The profits of investing in technology

Operational leverage is a common type of leverage in companies with high fixed costs and low variable costs,  common when manufacturing systems based on automated production processes are established. Technifying production processes involves investing in fixed costs (technology) in order to improve quality and increase production. An increase in operating profits is sought when companies increase their sales as a result of a successful technological investment. Thus, when the objectives are achieved, total costs decreaseand prices are lowered to gain competitiveness. This is how, within the process known as operating leverage, based on an investment policy in fixed assets or technology, results are maximized, sales are increased and, finally, greater profitability is achieved. The Degree of Operating Leverage (GAO) measures the result of this shift from variable costs (labor) to fixed costs (depreciation), resulting in a change in the level of operating profits that normally generates profitability.

High operating leverage

To achieve success with operational leverage, it is necessary to achieve greater profitability using the tools available in everyday business activities, without resorting to external tools, as is the case with financial leverage. Operating leverage may have different degrees. When it is said that a company has a high operating leverage , the greater its risk, and at the same time we are affirming that a change in its sales will not have an excessive impact on its profits, raising them.

Financial leverage

Leverage is the result of management decisions taken by companies to assume fixed costs to obtain the use of certain material resources (use of capital goods through operational leverage) or financial resources, which involve resorting to sources of external financing. The benefits, therefore, can be affected by both operating leverage and financial leverage , in which case Leverage outside the main business is used to multiply profitability. In this case, it is done through indebtedness in order to finance an operation, although there is a risk of insolvency, as losses can also increase exponentially. Not surprisingly, when leverage levels increase, so do the risks.

 

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