Ways to Increase Operational Leverage

A company with a high degree of operating leverage is more profitable than one with a low operating leverage.

Operating leverage is an evaluation measure used by a business to measure the extent to which a company's earnings before interest and taxes change with a change in sales. Increase in operating leverage leads to a huge growth in profitability. To have a high operating leverage, a company should have a high proportion of fixed costs compared to variable costs and increase its sales.

Maximize Fixed Inputs

Fixed inputs such as employees, rental premises, equipment, advertising, depreciation and insurance should be utilized to their full potential. This may be done by training and motivating workers, getting rid of underperforming employees, converting idle premises into storage or office space, and increasing output of capital equipment such as machines through regular servicing and maintenance. This reduces the unit costs of production, as more units are produced at the same level of fixed cost.

Reducing Variable Costs

Variable costs include sales commissions, raw materials, office supplies, electricity, distribution and packaging. The amount of commissions may be reduced by introducing a fixed-salary pay plan while raising the targets for each individual salesperson. The company may also lower its raw material costs by bypassing middlemen and instead purchasing from the original supplier. A waste recycling program may also be introduced to save on raw material costs. Transportation costs may be lowered by transporting goods in bulk.

Increasing Sales

To increase the operating leverage, increase the volume of your sales. Use marketing strategies such as involving a reputable public relations firm to promote the awareness of your brand. You may also join business and professional clubs, where you can market and possibly sell your product to group members. You may also develop customer reward programs, offer incentives and improve the quality of existing products.

Obtaining Additional Financing

A company may apply for long-term bank loans, retain a portion of its profits and issue new shares or bonds to obtain additional funding to expand its operations. By expanding its operations, a company's productivity increases. The company should also ensure that costs, especially variable costs, don't increase as the level of production goes up. This leads to a high operating leverage, which leads to an increase in profitability.

References

• "Fundamentals of Corporate Finance, 5th edition"; Richard A. Brealey; 2007
• "Maximizing Production Effectiveness, TPM in Process Industries"; Tokutaro Suzuki; 1994
• Vorne: Reducing Manufacturing Costs
• "Financial Management, 10th edition"; I.M. Pandey; 2010
• Tutor2U: Sources of Finance for a Start-Up Business