Operating leverage is a ratio that represents the relationship between the contribution margin and operating income: the difference between those two amounts is fixed costs. The ratio measures the degree to which a company can increase its operating income by increasing sales.

Operating leverage = contribution margin/operating income

In other words, operating leverage predicts the effect of a change in sales on operating income. The percent increase (decrease) in sales is multiplied by the operating leverage to find the percent increase (decrease) in operating income. The higher the operating leverage, the more impact a change in sales will have on operating income.

Let’s compute the operating leverage for BlankBooks, Inc. at a sales level of 2,900 units:

Contribution margin / operating income = 4,930.00 / 1,530.00 = 3.2222…

This indicates that a 1% increase in sales would increase operating income by 3.22%.

Theoretically then, an increase in sales of 20% would increase operating income by 20% X 3.22, or 64%. An increase in sales of 20% would be equal to $5,800.00 ($29,000.00 * 0.20), which should then increase the bottom line by $979.20 ($1,530.00 * 0.64).

The actual number will be slightly different because we rounded the factor from 3.222… (repeating forever) to just 3.22 and then rounded further when we rounded 0.20 * 3.22 from 64.4% to 64%. This results in an accumulation of errors. If we didn’t round, we would get 0.6444… (repeating forever), which would result in an increase in the bottom line of $986.00.

By increasing unit sales by 20%, we increased the bottom line from $1,530.00 to $2,516, a nominal increase of $986.00.

In terms of units, we went from 2900 to 3480, an increase of 580 units, which is 20%.

Every company compensates for rounding errors in its own way, and it’s important to remember that almost everything you do in managerial accounting is to aid in decision-making. So as long as the results of our analysis have followed correct principles in the calculations, minor rounding errors should not have a major impact on the ultimate decision-making.

Notice that at this level of sales/production, our operating leverage number is now 2.35.

Contribution margin / operating income = 5,916 / 2,516 = 2.35135 (repeating decimal).

Now, let’s check your understanding of the concept of operating leverage.