What is operating leverage and financial leverage? What is their significance?

Operating leverage is a cost-accounting formula that measures the degree to which a firm or project can increase operating income by increasing revenue. A business that generates sales with a high gross margin and low variable costs has high operating leverage.

Operating leverage is used to calculate a company’s break-even point and help set appropriate selling prices to cover all costs and generate a profit.

Companies with high operating leverage must cover a larger amount of fixed costs each month regardless of whether they sell any units of product.

Low-operating-leverage companies may have high costs that vary directly with their sales but have lower fixed costs to cover each month.

The higher the degree of operating leverage, the greater the potential danger from forecasting risk, in which a relatively small error in forecasting sales can be magnified into large errors in cash flow projection.

It is important to compare operating leverage between companies in the same industry, as some industries have higher fixed costs than others. The concept of a high or low ratio is then more clearly defined.

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