For example, suppose Company ABC had $100,000 in total sales in December, 2015. Variable expenses were: cost of goods sold - $30,000; sales commissions – 20,000; delivery expenses - $10,000. The contribution margin is $100,000−$30,000−$20,000−$10,000=$40,000{\displaystyle $100,000-$30,000-$20,000-$10,000=$40,000}.

Suppose Company ABC’s fixed expenses were: advertising - $2,000; insurance - $5,000; rent - $3,000; utilities - $2,000; wages - $18,000. Total fixed expenses are $30,000. Operating income is total sales less variable and fixed expenses. For Company ABC, the total sales were $100,000. The variable expenses are $60,000 and fixed costs are $30,000. Operating income = $100,000−$60,000−$30,000=$10,000{\displaystyle $100,000-$60,000-$30,000=$10,000}.

Operating leverage = contribution margin / operating income. $40,000/$10,000=4{\displaystyle $40,000/$10,000=4} Company ABC’s operating leverage is 4.

The higher your fixed expenses are as a percentage of total expenses, the higher your operating leverage is going to be. Higher operating leverage means that your net income grows at a faster rate.

The contribution margin is $100,000−$30,000=$70,000{\displaystyle $100,000-$30,000=$70,000}. The operating income is $100,000−$30,000−$60,000=$10,000{\displaystyle $100,000-$30,000-$60,000=$10,000}. Operating leverage = contribution margin / operating income. $70,000/$10,000=7{\displaystyle $70,000/$10,000=7}. Company XYZ’s operating income grows 7 times as fast as its sales.

Suppose the two companies in the above examples each had a 10 percent increase in sales. For company ABC with an operating leverage of 4, net profit margin should increase by 40 percent with a 10 percent increase in sales (10%∗4=40%){\displaystyle (10%*4=40%)}. For company XYZ with an operating leverage of 7, net profit margin should increase by 70 percent with a 10 percent increase in sales (10%∗7=70%){\displaystyle (10%*7=70%)}. Therefore, you can use the operating leverage to quickly calculate the impact of changes in sales on your operating income without having to prepare detailed financial statements.

Investors should be cautious when investing in companies with high operating leverage.