Operating Leverage

Abstract

Abstract Operating leverage refers to the use of fixed inputs versus variable inputs in the production of goods and services. A firm with high operating leverage employs more capital as opposed to labor or other variable inputs in its production processes. Operating leverage is related to financial leverage because a firm that uses more operating leverage must fund its investment in fixed assets through debt or equity, affecting the financial leverage of the firm. The level of operating leverage affects risk through the firm's commitment to fixed costs, which raises the break‐even level of output. When sales volume (output) falls below the break‐even level, losses mount as long as fixed assets cannot be shed. Conversely, when firm sales are above the break‐even level, profits mount because of the low incremental (variable) costs of additional units produced.