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What Is Operating Leverage?

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  • Written By: Osmand Vitez
  • Edited By: Kristen Osborne
  • Last Modified Date: 23 July 2014
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Operating leverage is a calculation organizations use to determine the amount of fixed cost in their business operations. Companies use two types of costs when running a business: variable and fixed. Variable costs change as the companies use more or less of an item. Fixed costs do not change and remain constant for the entire duration of the business operation. Certain companies are prone to having a higher operating leverage based on their extensive use of fixed costs in their business operations. The manufacturing industry is a classic example where companies have high amounts of fixed costs.

Manufacturing companies typically require large equipment, machines or other significant business assets to help produce goods for consumer or business use. Most companies purchase these assets using bank loans or other external financing methods; external financing requires companies to make monthly payments, a fixed cost, to pay for these assets. Fixed costs may also be attributed to other production processes in a manufacturing company. A high percentage of fixed costs indicates the company has a high operating leverage that must be offset through the efficient production of consumer goods.

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Companies with large amounts of salaried workers may also have a high degree of operating leverage. Salaried labor means that these individuals must be paid regardless of the amount of goods or services they produce for the company. Offering benefit packages to salaried workers, such as vacation or personal time, performance bonuses or annual increases in compensation, will also increase the company’s amount of operating leverage since these costs can only be avoided by firing or laying off salaried employees.

High levels inventory merchandise is also a factor in a company’s operating leverage. Inventory usually requires warehousing and personnel to maintain the inventory for the business prior to selling it to consumers. Adding warehouse facilities to store inventory will increase the company’s fixed costs and its operating leverage.

Business technology has allowed companies to implement business practices that can significantly decrease operating leverage. Companies often times transfer information electronically between retail outlets and warehouses, allowing automated re-orders to take place rather than retail companies holding on to more inventory than is necessary. Companies can also decrease labor costs by using websites or self-service kiosks for performing business services or collecting consumer information. Business software may also allow companies to improve manufacturing or production processes, decreasing the amount of labor or maintenance costs needed to produce goods or services.

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Discuss this Article

hamje32
Post 4

@David09 - One way to keep the cost of capital down, especially when you’re talking about human capital, is simply to employ contractors instead of full time employees.

I know that’s not good news to the full time employees, but you’ve just got to roll with the times. If you can contract, then that’s what you have to do. No, you don’t get the health benefits and 401K but at least you can keep a roof over your head.

SkyWhisperer
Post 3

@nony - I’ve heard that some software is effective in managing inventory for manufacturing companies. They have these things called Kanban software systems that will determine when to ramp up production or slow it down, so you never produce too much or too little.

As a result you will avoid the added costs associated with too much or too little inventory. I don’t know if they have similar software for other industries but I think that it’s an ideal tool for keeping costs low.

David09
Post 2

@nony - Even the service industry has its own challenges. I work at a software company where our fixed costs are virtually nothing. Software is a digital product that can be downloaded over the Internet.

However this year the company president told us that he had hired too many employees and that as a result we were incurring a fiscal loss. He warned that there might be layoffs.

So yes, we don’t have much in the way of infrastructure, but too much in the way of salaried employees. I’ve been laid off before so the news didn’t scare me; I’m a survivor.

nony
Post 1

I worked in the telecommunications industry for over ten years. We had very high operating leverage in the business, because we were very infrastructure intensive.

We bought networks, thousands of miles of fiber, switches, etc. – all so we could sell telephone services to our customers. The company incurred a high debt ratio to service all of this equipment.

In addition, to maintain this massive infrastructure we employed thousands of people. As a result, when the industry imploded, the company had to lay off a lot of people and sell a lot of our fiber assets to smaller telecoms looking to scoop up assets at fire sale prices.

I personally think that firms with a high degree of operating leverage are susceptible to these kinds of boom and bust cycles. I prefer the service industry, where fixed costs are kept to a minimum.

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