Lesson 5 of 7 · 14 min
Operating costs and operating leverage
How much of a company's cost base is fixed decides how violently operating profit reacts to a change in sales; operating profit = Q × (P − VC) − FC, and the degree of operating leverage measures the sensitivity.
In short
- Operating costs relate to current-period revenue; investing costs buy long-term assets; financing costs reward debt and equity investors. Accounting classification does not always follow this intuition.
- Operating costs can be categorised by behaviour (fixed vs variable), nature (what the cost is) or function (what it is for).
- Operating profit = . The contribution margin (P − VC) must be positive and Q must be high enough to cover FC.
- Degree of operating leverage (DOL) = %Δ operating profit / %Δ sales. More fixed and fewer variable costs mean a higher DOL: faster profit growth in good times, faster falls in bad.
- IFRS and US GAAP do not require fixed/variable or volume disclosure, so this analysis is often limited, except in industries such as oil and gas where it is customary.
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