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.
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.