The effect of operating leverage (or production leverage) makes it possible to determine the most advantageous combination of the relationship between price, volume of production, fixed and variable costs. The analysis of the results obtained allows economists to make adequate management decisions in the field of pricing and assortment policies.
Operating lever mechanism
The leverage effect is based on dividing costs into fixed and variable costs and comparing revenue with those costs. The effect of production leverage is manifested in the fact that any change in revenue leads to a change in profit, and profit always changes more than revenue.
The higher the proportion of fixed costs, the higher the production leverage and entrepreneurial risk. To reduce the level of operating leverage, it is necessary to seek to translate fixed costs into variables. For example, workers employed in manufacturing can be transferred to piecework wages. Also, to reduce depreciation costs, production equipment can be leased.
Methodology for calculating operating leverage
The effect of operating leverage can be determined using the formula:
Let's consider the action of production leverage on a practical example. Let's assume that in the current period the revenue was 15 million rubles., variable costs amounted to 12.3 million rubles, and fixed costs - 1.58 million rubles. Next year, the company wants to increase its revenue by 9, 1%. Determine with the help of the force of influence of the operating leverage how much interest the profit will increase.
Using the formula, calculate the gross margin and profit:
Gross margin = Revenue - Variable costs = 15 - 12, 3 = 2, 7 million rubles.
Profit = Gross margin - Fixed costs = 2, 7 - 1, 58 = 1, 12 million rubles.
Then the effect of the operating leverage will be:
Operating Leverage = Gross Margin / Profit = 2, 7/1, 12 = 2, 41
The operating leverage effect is how much the percentage will decrease or increase profit when revenue changes by one percent. Therefore, if the revenue increases by 9, 1%, then the profit will increase by 9, 1% * 2, 41 = 21, 9%.
Let's check the result and calculate how much the profit will change in the traditional way (without using operating leverage).
With an increase in revenue, only the variable costs change, and the fixed costs remain unchanged. Let's present the data in an analytical table.
Thus, the profit will increase by:
1365, 7 * 100%/1120 – 1 = 21, 9%
