It is important for a company that the sum of its efforts is reflected in the generation of a gross profit. To achieve this, it is necessary to have strategies that maximize profits and reduce costs; one of the main strategies that companies usually use is to employ operating leverage.
To achieve this type of strategy, it is necessary to achieve a proportion where fixed costs replace variable costs. This will allow profitability to have an increase in gross margin and improve the company’s economic health.
What is the operating leverage?
The financial leverage is the count noun and financial that is given to a strategy in which the gross profit of the company is increased through the modification between the balance of costs that are fixed and variable costs, which in a company have a direct effect on the level of profitability.
In other words, the substitution of variable costs for fixed costs will allow, for example, in a production company, the profit margin between the quantity of unit sold and the costs incurred, this will increase the profit per unit sold, which generates greater profitability, generating in turn greater operating profit.
In general, operating leverages are established in companies that have an automatic production system, that is, the technical procedures in production are efficient, and the company has invested in expanding its production capacity through implementation through new technologies.
What is the risk of Operating Leverage?
When a company assumes to apply operating leverage to improve its gross profit, it is exposed to great risk. Although they can increase profits, an error in planning or execution can also generate significant losses for the company.
This is because, in automatic processes, a small error can greatly impact the final products since this error would affect each of the production stages.
On the other hand, in a booming economy, having a high operating leverage level helps to maximize profits. Still, the market due to various factors can change, and in a country that is in crisis, it can make sales levels fall, and the high level of fixed costs that the company possesses affect its liquidity and convert the result from profit to loss.
What are fixed and variable costs?
In general, the costs are those expenses that the company must incur directly for the provision of a service or produce a good, as they are necessary to generate a profit; these are deducted from the sales it has made, and thus profitability is measured.
Based on the above, fixed costs are those that are kept constant from month to month, and that does not vary regardless of the level of production, on the contrary, variable costs are closely related to the number of services or goods produced, to The greater the number of the former, the greater the implicit cost to carry them out.
The classification of fixed or variable will depend on the company’s line of business. However, the expenses of basic services such as electricity or water will be a fixed expense in a company that provides an accounting service compared to a production company that will spend a higher light level depending on the production level you have a month to month.
Advantages and disadvantages of Operating Leverage
Like the other management decisions of a company, operating leverage will be functional to the extent that internal and external conditions are aligned. Otherwise, the risk of the company obtaining a bad economic situation is quite high.
For this reason, we point out one by one of the main advantages and disadvantages offered by operating leverage.
Difference between Operating Leverage and Financial Leverage
Operating leverage is based on the company’s internal management and its production capacity. On the other hand, financial leverage arises from the company’s need to seek financing from third parties in order to improve its economic position.
This indebtedness arising from third-party financing can have positive or negative effects depending on the efficiency with which the capital received from third parties is used and the impact on the improvement of the company’s profit margins.
It is important to mention that another difference is that the financial lease generates a financial cost for the interests that must be paid due to the capital obtained. Although the gross profit is not compromised, the net profit will reflect the effect of financial interests.
The operating leverage searches that through fixed incomes in their costs, their margins improve profit. On the other hand, financial leverage is a strategy that uses third-party capital to improve some of my processes, even if this means me a liquidity risk and a financial interest expense.