Operating leverage

High operating leverage (also known as operating gearing) means that fixed costs (predominantly property and staff) are a high proportion of total costs in the profit and loss account.

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.

Most Popular

Five dividend stocks to beat inflation
Share tips

Five dividend stocks to beat inflation

During periods of high inflation, dividend stocks tend to do better than the wider market. Here, Rupert Hargreaves pick five dividend stocks for incom…
30 Jun 2022
Don’t try to time the bottom – start buying good companies now
Investment strategy

Don’t try to time the bottom – start buying good companies now

Markets are having a rough time, so you may be tempted to wait to try to call the bottom and pick up some bargains. But that would be a mistake, says …
1 Jul 2022
UK house prices are definitely cooling off – but are they heading for a fall?
House prices

UK house prices are definitely cooling off – but are they heading for a fall?

UK house prices hit a fresh high in June, but as interest rates start to rise, the market is cooling John Stepek assesses just how much of an effect h…
30 Jun 2022