The effect of operating leverage (production) is a rapid change in net profit with an increase in revenue from sales. It occurs under the influence of fixed costs for the production process and sale. At the same time, these expenses remain unchanged, and revenue is growing.
The strength of the operating leverage shows how many percent there will be a change in profit with an increase (decrease) in revenue by 1%. The higher the proportion of expenses (fixed) used in production and sales, the more powerful the lever. The formula for its definition: the difference between revenue and costs / profit.
The definition of "lever" is used in various sciences. This is a special device that allows you to enhance the impact on a particular object. In the economy, the role of such a mechanism is fixed costs. The operating leverage reveals how the enterprise depends on the costs included in the cost of production. This indicator characterizes business risk.
The effect of operating leverage is that even a small change in revenue leads to a stronger increase or decrease in profit. Suppose that the proportion of fixed costs in the cost of production is large, then the company has a very high level of production leverage. Consequently, the business risk is significant. If such an enterprise even slightly changes the sales volume, it will receive a significant profit fluctuation.
Each organization has a break-even point. In it, the level of operational leverage tends to infinity. But with a slight deviation in sales from this point, a completely significant change in profitability occurs. And the greater the deviation from the breakeven point, the less revenue the company receives. It is worth considering that almost all firms are engaged in the production or sale of several types of products. Therefore, the effect of operating leverage must be considered for the total revenue from sales and for each product (service) separately.
In the case when there is an increase in fixed costs, it is necessary to choose a strategy aimed at increasing sales volumes. In this case, it does not matter even a decrease in the level of variable costs. The effect of operating leverage is affected only by fixed costs. Analysis of it is important for financial managers. Learning the operational leverage helps you choose the right strategy for managing profit, costs and business risk.
There are several factors that influence the level of production leverage:
- price at which the products are sold;
- volume of sales;
- costs, mostly fixed.
If the market has developed an unfavorable situation, then this leads to a decrease in sales. Typically, this situation develops at the first stage of the product life cycle. Then even the breakeven point has not been overcome. And this requires a significant reduction in fixed costs, the calculation of financial leverage. Conversely, when market conditions are favorable, cost control can be slightly relaxed. A similar period can be used to modernize fixed assets, to invest in new projects, purchase assets, etc.
The industry affiliation of the enterprise dictates certain requirements for the size of investment, automation of labor, for the qualifications of specialists, etc. If the organization works in the field of engineering, heavy industry, then managing the operating lever is difficult. This is associated with high fixed costs. But if the company is engaged in the provision of services, then the regulation of operational leverage is quite simple.
Purposeful management of variables and fixed costs, changing them depending on the current market situation will reduce business risk and increase the company 's profits.