Operating Leverage Explained: How Fixed vs Variable Costs Drive Profit Volatility

What Is Operating Leverage?

Operating leverage sounds like complicated finance jargon, but it's a simple concept beneath all the noise. It’s all about how a company’s cost structure affects profit growth.

It can be used to understand how a change in revenue translates into operating income in percentage terms. In simple terms, operating leverage explains how small changes in revenue can lead to big swings in earnings.

The whole thing comes down to the cost base. In particular, it boils down to fixed costs vs. variable costs.

How Operating Leverage Works (Fixed vs. Variable Costs)

Every business deals with two types of costs. Fixed and variable.

Fixed costs don’t care whether you sell one unit or a million. They’re stubborn. Things like rent, equipment leases, and salaried employees. They’re on the books whether your revenue is booming or flatlining.

That bakery on the corner pays the same to lease its oven and storefront whether it pumps out 10 loaves or 100. This creates a break-even point. Sales need to hit a certain level before the business turns a profit.

Variable costs, on the other hand, scale with production. More units sold means more costs. Ingredients, packaging, shipping, and hourly wages.