Operating leverage

What do banks, airlines and hotels have in common? The answer is high operating leverage (also known as operating gearing). This means that fixed costs (predominantly property and staff) are a high proportion of total costs in the profit and loss account. As a result, profits are highly sensitive to changes in sales compared to another business with much lower leverage.

Say a firm has £100 of sales (or, ‘turnover’) £80 of fixed costs and £10 of variable costs; profit is £10 (100-80-10).Operating leverage is a substantial 89% (80 as a proportion of 90). If sales rise the following year by just 10% to £110, fixed costs remain constant and variable costs also rise by 10% to £11 the new profit figure is £19 (110-80-11), a huge rise of 90%. Conversely had sales declined suddenly by 10%, profits would have been wiped out.

In an economic downturn firms with high operational leverage, like banks, have to react very quickly, often by dumping staff, to stay alive.

Merryn

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