A company's operating leverage is the ratio of the change in business operating income to the change in sales. Operating leverage is a method of measuring the volatility of an asset's earnings relative to sales, i.e. how operating income changes as the sales volume changes. An asset with higher operating leverage is riskier than an asset, belonging to the same sector, with lower operating leverage. This guide explains in a few quick steps how to calculate the operating leverage of an asset.
Steps
Step 1. Calculate the revenue and variable costs for each unit of product sold (whether they are objects or services)
As an example, let's consider a factory that last year produced and sold 1,000 units, with a corresponding turnover of 100,000 euros
Step 2. Divide your total revenue by the number of units sold
In this way you will find the turnover per single unit, i.e. the selling price of the single unit.
In our example, the total turnover of 100,000 euros must be divided by 1,000 units, which means that each unit of product was sold for 100 euros
Step 3. Subtract fixed costs and operating income from your total revenue
- Fixed costs are costs that do not change based on the quantity produced. For example, the expenses for maintaining the production premises or for advertising.
- Continuing with the previous example, if the fixed costs are equal to 20,000 euros and the operating income is 10,000 euros, then I have to subtract from the total turnover of 100,000 euros, 20,000 euros for fixed costs and 10,000 for operating income. The remaining total is 70,000 euros.
Step 4. After subtracting fixed costs and operating income from total revenue, divide the result by the number of units produced:
in this way you will find the variable cost of each unit produced.
- Variable costs change based on the number of units produced. These costs include, for example, raw materials.
- In the example, the difference between total turnover and fixed costs and operating income is 70,000 euros. Divide 70,000 euros by 1,000 units produced and you will find the variable cost for each unit produced, i.e. 70 euros.
Step 5. Calculate the contribution margin, ie the variable return obtained for each unit sold
- This is the difference between the selling price per unit and the variable cost per unit.
- Continuing with the example, if we have established that the selling price of each unit produced is 100 euros and the variable cost of each unit produced is 70 euros, the contribution margin for each unit is 30 euros.
Step 6. Multiply the variable revenue per unit by the number of units of product sold
So you find the total variable return.
