Operating leverage
Fixed operating costs magnifying what a change in sales does to operating profit. A company with no debt at all can be dangerously leveraged.
Where you will meet it
Operating leverage appears in 4 learning outcomes on the CFA syllabus. A few of them:
- Explain how a forecast model for a share projects sales, margins, investment and funding
“Margins come from forecasts of cost of sales and operating expenses, often as percentages of revenue with fixed costs treated separately to capture operating leverage.”
- Construct a pro forma income statement driven by sales
“Cost of goods sold and variable selling expenses follow a margin or percentage of sales; fixed costs are modelled separately, since treating them as variable understates operating leverage.”
- Explain how the stage of the business cycle shapes expectations for earnings growth over both short and long horizons
“In a recession current profits fall sharply, especially for cyclical firms with high operating leverage, and forecasts for the next year or two are cut; in recovery they rebound quickly.”
- Assess what drives a firm's revenue, how profitable its operations are and how much pricing power it has
“Operating profitability depends on the cost structure: a business with high fixed costs has strong operating leverage, so margins widen sharply when revenue grows and shrink sharply when it falls.”
See also
Practise it
Practise operating leverage until it is automatic: questions that explain every wrong option.
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