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Operating leverage is a helpful cost-accounting tool you can use to set prices and ensure you’re breaking even each month. In real estate, your operating leverage includes fixed costs such as mortgage payments, taxes, maintenance, internet and any other fixed costs you need to run your business.
Operating leverage describes a company’s total fixed costs. Leverage is a form of debt that is used to create a company’s products or services. Operating leverage is the amount of debt that must be used each month to cover fixed costs and keep a company operating. In essence, operating leverage is an analysis of a company’s fixed costs and variable costs. Companies with high operating leverage tend to have higher fixed costs than variable costs. If a company has low fixed costs in relation to its variable costs, its degree of operating leverage (DOL) is low. Ultimately, a business with a high gross margin and low variable costs has a high degree of operating leverage (DOL).
Operating leverage is a leverage ratio used in accounting to track and measure a company’s ability to cover its costs and increase revenue. It can be used to find a company’s break-even point. If you own a company, you want to know exactly how many sales you need to make each month to cover your expenses. Use operating leverage to adjust prices, lower fixed costs and set sales goals.
Also called the degree of operating leverage, the operating leverage formula is:
Operating Leverage = Contribution Margin / Profit
Another way to write the formula for the degree of operating leverage is:
Operating Leverage = Number of Units x Contribution Margin / Number of Units x Contribution Margin – Fixed Operating Costs
Contribution Margin = Price – Variable Cost per Unit
Profit = Total Revenue – Total Expenses
Let’s say you own a 50-unit multifamily property. Tenants pay $1,100 a month rent and their own utilities. Your fixed costs are your mortgage, property tax and commercial property insurance, which equal $40,000 a month. Your variable costs include maintenance fees and utilities for common areas, which average about $100.
Your operating leverage formula would look like this:
50 x ($1100 – $100) / 50 x ($1100 – $100) – $40,000 = 1.25 or 125%
Your degree of operating leverage would be 125%.
As shown in the example above, real estate investment companies generally have mid-range operating leverage, though it’s important to remember that it’s all relative. You can lower your operating leverage further by passing off some of your fixed costs (and variable costs) to your tenants.High and low operating leverage describe the amount of risk a company takes on to operate. These descriptors are neither “good” nor “bad.” They simply give you an idea of your break-even point so you can determine how much rent you need to collect to pay your operating costs and make a profit. All that matters is whether or not you can cover your costs each month.
Companies that have high operating leverage also have a higher risk. Because they spend more on monthly costs to supply their product or service, they must make more in sales each month to cover their costs. An example of an industry with high operating leverage is the airline industry. To operate, airlines have huge monthly costs in cleaning, maintenance, jet fuel, pilots, staff and more. Companies must ensure they sell enough tickets to cover these costs. Low operating leverage means a company has less risk. They are less dependent on making sales to cover their costs. An example of a company with low operating leverage is a home-based monogram business. While there was an initial upfront cost to purchase a monogramming machine, monograms are performed to order. Therefore, the few materials needed to monogram an item are purchased as an order is received. There are fewer costs.
If you don’t know your operating leverage, you’re leaving your business in the dark. Find your break-even point and figure out how to lower your fixed costs with operating leverage today.
