Operating leverage, or production leverage, is needed to manage profit and is based on improving the ratio of variable and fixed costs. It shows the degree of profit sensitivity to changes in sales volumes, product prices and costs. With the help of operating leverage, you can predict the amount of profit, knowing the possible change in these indicators.
It is necessary
- - calculator;
- - knowledge of accounting and financial analysis.
Instructions
Step 1
The calculation of operating leverage should begin with the allocation of costs to fixed and variable costs. This cost-sharing mechanism is called the marginal method. The change in production volume has no effect on fixed costs. These include depreciation, rent, utility costs. Variable costs are in direct proportion to the volume of production. Among them are the costs of raw materials and supplies.
Step 2
There are three main components of operating leverage: price, variable and fixed costs. These metrics are related to sales. Their change directly or indirectly affects sales and revenue. The change in revenue, due to each component, has a different effect on the dynamics of profit. Competent management of these indicators allows you to ensure the amount of operating leverage at an acceptable level for the enterprise.
Step 3
The price operating leverage shows how much the profit will change if there is a 1% change in revenue. If the enterprise has a high level of operating leverage, then even a small change in production volume significantly affects the amount of profit. In this case, the calculation formula is as follows: ORts = (Revenue / Profit) * 100%. Revenue is the sum of profit, fixed and variable costs.
Step 4
You can also calculate the natural operating leverage, or operating leverage, based on the volume of sales. It is calculated using the formula: ORv = (Gross Margin / Profit) * 100%. Gross margin is the difference between sales revenue and variable costs.
Step 5
Operating leverage for variable costs is the ratio of variable costs to earnings, expressed as a percentage. It shows by what percentage the profit will change when variable costs change by 1%. In the same way, you can calculate the operating leverage at fixed costs.
Step 6
The effect of operating leverage is that any larger change in sales revenue generates an even larger change in profit. Operating leverage is a measure of how many times the rate of change in profit outstrips the rate of change in revenue. The lower the level of fixed costs, the lower the operating leverage.
