A lever is defined as a rigid bar that pivots about at one point and that is used to move an object at a second point with a force applied to a third point. Operating leverage is a force used to increase the profitability of a business to its owners. Just as a lever functions in physics, operating leverage balances a variety of costs in order to move profits upward when pressure is applied to particular areas of operation.
A business can use operating leverage by weighing the mix of fixed and variable costs in its operations. When the fixed costs such as labor and raw materials are manipulated, profits can drastically increase. A company may increase its annual fixed machinery cost by upgrading to automated machinery. As a result, the cost of labor and raw materials needed per unit decreases. The outcome is more profit.
Companies with high leverage at play tend to have greater fluctuations in profits than companies with low operating leverage. A low-leveraged, manual operation will have fairly stable profit returns. They won’t experience the dips from a drastic increase or decrease of sales that high-leveraged companies do.
High-leverage companies also have a higher break-even sales point than the break-even point for a company with less leverage. Overall, operating leverage has the ability to improve a company’s profits for a given level of sales. However, the company must be aware of the risk involved in highly leveraging their operations. They risk an unstable profit pattern and an increased break-even sales level.