What does the term 'operating leverage' refer to?

The term 'operating leverage' refers to the degree to which a firm uses fixed costs in its operations, which has a significant impact on how sensitive profit is to changes in sales volume. When a company relies heavily on fixed costs, a relatively small increase in sales can lead to a disproportionately large increase in profit. This occurs because fixed costs remain constant regardless of the level of sales, so as sales increase, the same total fixed costs are spread over more units, leading to higher margins on each additional unit sold.

Understanding operating leverage is crucial for businesses because it affects their break-even point and the overall risk associated with their operations. Companies with high operating leverage can experience significant fluctuations in profitability with changes in sales, which can lead to both opportunities for higher profits during good economic times and greater risks during downturns. This concept highlights the balancing act companies must perform between fixed and variable costs to optimize their profitability and risk.