What does operating leverage measure in a company's cost structure?

Operating leverage measures the impact of changes in sales on a company's profitability. Companies with high operating leverage have a larger proportion of fixed costs in their cost structure compared to variable costs. This means that as sales increase, profits can rise significantly due to the fixed costs remaining constant; the added revenue contributes directly to the bottom line. Conversely, if sales decline, the same fixed costs can lead to a larger decrease in profitability, highlighting the degree of risk involved.

By understanding operating leverage, management can make informed decisions about pricing strategies, cost management, and production levels, all of which are pivotal during fluctuating market conditions. This measure is essential for analyzing how sensitive a company's earnings are to changes in sales volume, which is critical in strategic planning and financial forecasting.