Operating leverage

How much profit changes for a given change in revenue. High fixed costs and a high CM ratio mean profits swing hard in both directions.

Example

A software company with £20k of fixed costs and a 85% CM ratio gains £850 of profit for every extra £1,000 of revenue — and loses it just as fast on the way down.

Important

Leverage is not a virtue. It is amplification. The same structure that makes growth spectacular makes a bad quarter existential, which is why high-leverage businesses need more runway, not less.

Related terms

• Fixed costs — Costs that do not change with sales volume in the short term — rent, salaries, software subscriptions, insurance.
• Contribution margin ratio (CM ratio) — Contribution margin as a percentage of revenue: (Revenue − Variable costs) ÷ Revenue. The share of every sales dollar left over to cover fixed costs and then become profit.
• Contribution margin — Revenue from a unit minus all the variable costs of producing and selling that unit — a step beyond gross margin because it also includes variable selling costs.
• Runway — How many months your company can keep operating before it runs out of money, at its current rate of spending.
• Scalability — The ability to serve many more customers without costs rising proportionally.

Lessons that explain it

• Break-even and operating leverage — The revenue that makes you self-sufficient, and why the same structure that makes growth spectacular makes a bad quarter dangerous. (12 min)

All 176 terms in the Founder glossary